What is Stop Loss Hunting?
Forex brokers make money by charging you whenever you take a position. For example, if you want to buy a currency pair, a forex broker will tack on a number of pips on your buy order. The number of pips added to a trade is referred to as the “spread,” and this is just about the only source of income for forex brokers.
There are two types of forex brokers. ECN/STP brokers function as “middle men”, sending your trades to liquidity providers (i.e. banks). Normally, they do not make money off spreads but charge commissions instead. The second type of forex broker functions as a market maker, which means it has its own dealing desk and takes the opposite side of your position. In other words, the broker trades against you. If you gain, the broker loses, and vice versa. Forex brokers of this kind make money off the spread as well as the swap and the money you lose on your trades.
You do not need to worry about honest, reliable brokers who generate their income through legitimate means. However, you have to be alert to the activities of a market maker, since a market maker turns a profit when you lose and has therefore a vested interest in seeing you in the red.
One of the tools that market makers have at their disposal to make sure that you lose is called “stop loss hunting.” Market makers may utilize special robots to perform this function. Equally, they may have specially trained staff to monitor client trades. The technique itself works as follows. Assume a client takes a short position. The client also sets a stop loss for protection. The market goes against the position and falls, but it does not fall far enough to reach the stop-loss price. The robot or one of the employees assigned to monitor client trading will then increase the spread manually so that, if the market continues to fall, the stop-loss order is triggered sooner.
Here is a concrete example to help illustrate the dynamics of stop loss hunting. Assume that you establish a short position with the EUR/USD currency pair at 1.3180. Following that, you also place a stop-loss order at 1.3280. As you have taken a short position, you will need an offsetting buy order in order to exit the position. You will not pay the spread until you buy to close the position, which means that there are no spread-related expenses when you go short. Again, you will not pay the spread on your short order until you buy to close the short position.
In the scenario above, your stop-loss order is your offsetting buy order. To recap, you have established a short position at 1.3180 and a stop-loss order at 1.3280. Assume that the market goes against your position, up to 1.3275. At that level, the market is 5 pips away from your stop-loss price, so your stop-loss order (which, recall, is actually a buy order) should not be triggered. Unfortunately, though, this is where your broker has the maneuvering room to make a profit. Although you are still 5 pips away from your stop-loss price, the broker can trigger your order “artificially.” Assuming that your broker charges 2 pips for EUR/USD trades, the broker may opt to apply the spread now, bringing your buy price from 1.3275 to 1.3277. Since your stop-loss order is at 1.3280, you are now only 3 pips away from being triggered. Still, you should be okay, right? Especially if the market backs off, changing its direction? Not so fast. Unfortunately, this is a perfect opportunity for unscrupulous brokers. Now that your buy price is only 3 pips away from your stop-loss order, your broker might simply add another 2 pips to the spread, charging you a total of 5 pips and bringing your buy price from 1.3277 to 1.3280. Your buy price has now hit your stop-loss order, triggering it, and your position is closed. You have lost money.
You walk away from the trade blaming the market and your own poor judgment that failed you on that trade, but the truth of it is that your loss has nothing to do either with the market or your judgment. You have only fallen victim to an unprincipled broker. The broker has artificially increased the spread to “force” the triggering of your stop-loss order, and the money that you have lost on the trade now belongs to your broker.