Recently we have received some questions regarding the difference between stop-entry and stop-loss, and when a stop loss becomes a trailing stop. Sometimes we do tend to take for granted some basic market knowledge but, alas, without solid foundations it’s impractical to build a proper trading strategy and that includes the knowledge of various order types and their usage.
The Basics of Forex Transactions
Let’s start from the basics. Every trade is a transaction between two counterparties. For example, if you want to buy some bread from the supermarket, you need someone to sell it to you. You exchange (your) money for (the shop’s) bread. Another frequent (and necessary) trade we all make in some fashion is buying money (payroll) in exchange for our time & labour.
In the financial markets, transactions occur because two different parties with two different agendas agree to take the opposite sides of the same transaction. Being able to find a counterparty quickly is a desirable trait for a market, because “liquidity” is something worth paying for. Foreign exchange is one of the most liquid markets in the world (even though post-2013 liquidity has been more and more scarce compared to the “good old days”) and only in extreme situations is it difficult to find a counterparty (for example during flash crashes or black swan events such as the SNB peg removal).
EURCHF 1MIN Chart from Reuters Eikon (interbank prices) – an example of very low liquidity
When you enter a trade order, you are instructing your broker to enter or exit a position. At first, placing trades may seem overly simple: push the “buy” button when you want to buy, and push the “sell” button when it’s time to exit. But as your skills are enhanced, you may wish to understand what kind of orders you’re actually using and what other types there are.
Liquidity Providers, Brokers, Traders
When you enter into a foreign exchange transaction, there are typically 3 people involved:
- You, the retail trader at the end of the food chain. You make money if your directional bet on the underlying security is correct in a certain amount of time. You pay a premium (spread) in order to trade in the market.
- Your broker, the middle man. Brokers allow us retail traders to interact with the market at will, and for this privilege they take a small fee called “spread” and sometimes a “commission”. Brokers are the only people that make a risk-free profit because they usually hedge their exposure and have a market neutral position. However, despite strong risk controls, black swan events can endanger brokers as well, as we have learned in 2015.
- The Interbank Market (the liquidity providers). A group of 10-12 big banks such as Citigroup, Goldman Sachs, Barclays, HSBC, who are the primary market makers in Foreign Exchange. Nowadays, the market making is almost 100% electronic (and appears to be more vulnerable to sudden shocks and/or liquidity gaps than the older “dealer-driven” markets).
Announcement made by a retail forex broker after the SNB black swan event. Brokers DO take on some risk, despite their plethora of controls. Lack of liquidity, which is becoming more and more common in FX, hurts all participants.
If you use only the buy and sell buttons, you may experience losses from slippage and from trading without a protective stop-loss order. Slippage refers to the difference between the price you expected to exit at, and the price at which the trade was actually filled. In fast-moving markets driven by news events, sudden announcements or lack of liquidity, slippage can be substantial and make the difference between a winning and losing trade. Certain order types instead, allow you to specify exact prices for trades, thereby minimizing the risks associated with slippage.
Order Types
The natural question is: what order types are there and why should I adpot one rather than another? The answer depends on what you are looking to accomplish.
Market Orders: Market orders are the easiest order type out there. It instructs your broker to buy (or sell) at the best price that is currently available. Retail Brokers usually make it really easy to execute this kind of order and with graphic interfaces (GUIs) that have big buttons, colourful backgrounds and intuitive mecchanics, they get retail traders to “click” on the big buttons more often than they should.
Currenex vs FXCM: which platform is clearly made for retail?
Typically, market orders will be executed immediately. The primary reason for using a market order is to get a guaranteed fill. If you absolutely need to get in or out of a trade, a market order is the most reliable order type. The downside, however, is that market orders do not guarantee which price you will be filled at. Using market orders only in markets with good liquidity can help limit losses from slippage.
Limit Orders: A limit order is an order to buy (or sell) at a specified price or better. A buy limit order (a limit order to buy) can only be executed at the specified limit price or lower. Vice versa, a sell limit order (a limit order to sell) will be executed at the specified limit price or higher.Limit orders protect you from slippage, but they do not guarantee you will be filled.
Stop Orders: Stop orders act like “pending market orders” and are the opposite of limit orders: a buy stop order must be placed at a price above the current market price, and a sell stop order must be placed below the current market price. Once the stop level has been reached, the order is automatically converted to a market order. In this sense, a stop order acts as a trigger for the market order. Consequently, stop orders are further defined as stop-loss or stop-entry orders: a stop-loss order would be below the market price if you are in a long position. A stop loss order would be above the market price if you were in a short position.
Conditional Orders: Conditional orders are advanced orders that are automatically submitted or cancelled if specified criteria are met. Conditional orders must be placed before the trade is entered, and are considered the most basic form of trade automation. Here we will speak about the OCO (One Cancels the Other) as many retail brokers allow this type of trade entry.
Our MT4 Order Group Script allows for complex order entry, placing stop entry, stop loss, limit profit and limit sell orders above and beyond normal market entries.
The OCO allows you to place several orders simultaneously. When one is filled, any remaining orders in the group are automatically canceled. The OCO is useful for both trade entries and exits. A bracket order, which places simultaneous stop and limit orders in the market, is perhaps the most popular use of an OCO. In an OCO bracket order, once either the stop or limit orders are reached, the remaining order is automatically canceled. The stop order serves as a protective stop-loss order in case the trade moves in the wrong direction; the limit order serves as a profit target. So a single OCO order can actually submit 3 single orders at once.
Retail vs Institutional Order Placement Strategies
Now let’s get a little practical. Which kind of order to use will depend on the strategy you deploy. An interesting study was done in 2005 regarding the habits of professionals and retail traders with regards to order placement. It highlighted one fact that continues to be true today: retail traders have a propension to use “Limit orders” whereas professionals tend to use “market orders”.
OANDA MT4 Open Order Indicator set to “Net Open Orders”
This habit becomes immediately apparent when we look at the displacement of orders on EurUsd by the clients of a large retail broker. The chart above clearly shows a predominance of “sell” orders above the current market price (and they can only be “limit” orders) and a predominance of “buy” orders below the current market price (and they can only be “limit” orders).
It is also quite evident how the average retail trader thinks. The main clusters of orders are positioned around previous supports or resistances. In short, most traders expect previous support or resistance to hold, and they place their orders there.
The amount of “stop-entry” orders is much lower.
OANDA MT4 Open Order Indicator set to “Net Open Positions”
Instead, by observing the open positions, another dynamic becomes clear. Retail traders are most likely enticed to use “market” orders more often than they should because the largest open positions happen to be at (or very close to) the current market price. I could be wrong, but this leads me to believe that there is a flurry of extremely short-term activity going on constantly. In short, retail folk are always at work scalping for whatever reason – instead of selecting their battles wisely.
There are definitely some differences in “retail trader” behaviour if compared to institutional trader behaviour. In particular:
- retail traders tend to use limit orders more than market orders. This may be due to the fact that they are less aware of the current market conditions and/or fundamental influences which makes them less confident about taking immediate action.
- retail standing limit orders tend to be further from the current market price. Basically retail traders are generally less confident about the current market stance and look for a “value entry” further away than institutionals do.
- institutional traders tend to have a strong preference for market orders. Therefore,institutions tend to demand liquidity from other traders.
- Institutional traders are likely to demand greater immediacy due to the perceived short term nature of their information about the security’s underlying value. Besides the demand for greater immediacy, their prowess, market knowledge and trading models allows them to know precisely when, where & why they should be in or out of the market, resulting in the greater use of market orders.
Over to You
In this blog post we have illustrated the most common order types in retail forex trading, along with some behavioural traits that differentiate retail traders from professionals. These basic order types (at market, stop entry, stop loss, limit entry) are sufficient to deploy successful strategies in the market. Trailing stops, OCO orders and more complex types can be implemented easily if you understand the basics.
Beyond the academic vernacular, in practice the key think is to make sure you fully understand your broker’s graphic interface and order entry system. It’s common sense: learn how to use the tool effectively before risking hard earned money on it. Back in the broker days, I would often receive phone calls from clients that erroneously entered into a position and had no idea how they got in, and were unsure of how to get out.
Avoid these “unforced errors”. Learn the order types, learn your platform well, and then get to work taking your orders one by one. Make sure your open positions have a stop loss for example. Make sure that you have profit targets and stop losses in the machine when you are away from screens or sleeping. Even without a precise strategy, common sense will help you make good use of the basic orders your broker provides.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.