If you asked me to state only one trading tool that is crucial to a trader’s success, I will tell you it’s the stop loss.
Without a stop loss, don’t even think about entering a trade.
If you know well that you’re serious with your trading career, you must use a stop loss in each single trade that you place.
However, a stop loss triggers bad emotions for some traders.
I’ve met traders who argue that the market knows where they place their stops.
I’ve also dealt with traders arguing that the stops put them out of trade.
That’s why I have written this article…
I will discuss the stop loss and teach you how to place proper stops so that you don’t get stopped when it’s too early.
In this article, you will learn…
What is a Stop Loss?
A stop loss order refers to an order that automatically closes a losing position immediately the price hits a pre-determined level.
The above figure clearly shows how the stop loss order works. After the trader made a purchase, the price moved well for a while.
This suddenly changed, and the price changed its direction. The red line marks the start of the losing position.
The trade will be closed immediately it encounters the stop loss order.
This will prevent the trader from incurring a severe loss.
For example, suppose you’ve a particular asset at $100. You don’t want to keep holding the asset when the price falls below $75. So, your goal is to sell it and close the position at that level.
There are two approaches to this:
You can follow the price manually and close the trade immediately the price hits $75. This is called a “mental stop.”
Or, you can place a stop-level at $75 which will automatically close your trade immediately the price hits your order.
In most cases, it is far better to have a stop-loss order instead of a mental stop.
A stop loss order will never sleep and it will keep on following the market and close your trade at the specified level.
You will then be safe from making heavy losses on a losing position.
The stop-loss price is the price at which you decide that you’re wrong for entering a particular trade.
When the price hits the predetermined position in a stop-loss order, the order will become a buy market order if used with a short position, and a sell market order if used with a long position.
The Importance of using Stop Losses
Forex is a very volatile trade. Using stop losses will help you avoid making heavy losses.
If you’re trading without using stop losses, it’s just a matter of time before a large losing position gets out of control and wipes the most of your trading profits, even your entire trading account!
The beauty about stop losses is that they cost nothing to implement. See it as a free insurance policy. Only some commission may be deducted when selling has been done.
A stop loss order will prevent you from emotional trade. Most traders tend to give the price another chance, thinking that it will come around.
This causes delay and procrastination, which results into severe losses.
If you want to remain in the game in the long run and grow your trading account, you must use a stop-loss order in each single trade that you take.
So, remember this rule…
Always use stop-losses!
A stop loss is a great tool for risk management. With a stop loss order, a trader can calculate the position size to take, the amount of money to risk in every single trade, and much more.
Types of Stop Losses
Most traders misunderstand the process of setting stop losses. The way you place your stop loss has an impact on the performance of your trade.
It has an impact on your risk:reward ratio and affects the expectancy of your trading system. It also determines the overall adaptability of your trading system.
A stop-loss order is just a stop-loss order, but they differ based on how traders use them. There are different ways of determining stop-loss levels, and these give birth to 4 types of stop losses.
I will be discussing them one-by-one. Let’s start…
#1: Chart Stop
The chart stop is the most common way of using the stop-loss order. Chart stops depend on important technical levels of a chart, like the support and resistance levels, Fibonaccis, trendlines, chart patterns, Elliot waves and others.
A trader who wants to go far will place a stop loss below an important technical level.
This is demonstrated below…
In the above chart, the resistance level is the black horizontal line.
After a breakout through this level, you could buy the pair with the hope that the price will keep on increasing.
The chart also shows that a good place for the stop loss order is the zone below a previous big bottom on the chart.
The red, bidirectional arrow shows the distance between the entry zone and the stop placement.
That is the amount that you will risk in the trade.
The trade will be in the positive provided the price is above the entry point.
The trade will be in the negative if it moves below the entry point.
The stop loss order helps you to limit your loss, but your profit remains unlimited.
The basic idea behind a chart stop is that important chart levels hold an increased number of buy orders since the market participants who missed the initial move need to enter the market at a favorable price.
If the stop-loss is placed just below that level, like in horizontal support levels, a position will be closed automatically any time that level breaks.
Similarly, a trader who wants to go short will place the chart stop just above crucial technical level.
Resistance zones normally hold a high number of sell orders, which can cause a price reversal.
Once a breakout happens on an important resistance level, no trader will want to stay inside a short position, and his trade will be closed automatically by the stop-loss order.
Chart stops give the best results among all stop loss types, hence, you should consider including them in your trades.
#2: Volatility Stop
This type of stop loss depends on the changing market conditions.
During times of high volatility, traders use a larger stop loss to account for the greater market swings.
During times of low volatility, traders in turn use a more conservative stop loss.
It’s true that volatility can increase risk, but a market that is not volatile doesn’t provide trading opportunities to traders.
Traders using volatility stops consider the volatility of the market to place the stop loss orders.
There are two approaches of making stop-loss decisions based on volatility…
Bollinger Bands
The first approach involves the use of Bollinger Bands.
Bollinger Bands are a technical indicator that measure how volatile a market is.
It has three lines, with the middle line being the moving average.
The other two lines are plotted two standard deviations below and above the moving average.
When volatility picks up, the Bollinger Bands will widen, and when volatility slows down, the Bollinger Bands will contract.
Average True Range
The second approach is the use of Average True Range.
ATR measures the average range of price over a given period of time.
When using the ATR reading, a trader should set the stop-loss outside the average range, ensuring that they are not stopped by simple noise in the market.
#3: Time Stop
In this type of stop loss, the trade is closed after a predetermined period of time.
It is a good choice for traders who don’t like the idea of leaving their trades open overnight or over the weekend.
For example, a day trader may close all his open trades at the end of the trading day, and swing traders who don’t need to have open trades over the weekend may close all their open trades by the end of Friday trading session.
Consider using a time-stop if the market does not seem to be moving in either direction.
This means that you’ve stayed for long without hitting your stop loss as well as your profit target.
Instead of leaving your money in a trade where there is no much movement, use a time-based stop loss to exit the trade after a certain period of time has elapsed.
You can then use that capital in another opportunity!
Time stops become more effective when they are combined with other types of stop losses.
In case you’ve an active trade at the end of the day or ahead of the weekend, you may choose to close it manually.
#4: Percentage Stop
This type of stop loss uses a percentage of your trading account to limit the total risk of a trade.
For example, suppose a trader has a $20,000 account and he is willing to risk 4% of his trading account on a single trade.
Such a trader can place the stop loss at a level that will ensure that his total potential loss is only $800.
Most traders choose the percentage stop as the best way of minimizing losses in the market.
However, you must know that the percentage stop involves placing the stop loss at an arbitrary level, provided the total potential loss does not exceed a percentage of the trading account.
You can get better results by combining chart stops with percentage stops.
This way, you should place a stop loss depending on an important technical level then manage your total risk by adjusting the position size of the trade.
Stop-Loss Trading Strategies
Stop losses provide traders with a risk management plan.
Here are some tips to help you incorporate stop losses in your daily trades to maximize profits and minimize risks…
#1: Place Stop Losses at Support & Resistance Levels
If you’ve read this article from the top, you know that I am talking about chart stops.
Chart stops form the most effective way of using stop-loss orders by traders.
First, identify the most important technical levels, which are normally the support and resistance zones in the chart.
Next, place your stop loss just a few pips above an important resistance level (if your plan is to go short), or just a few pips below an important support level (if you are planning to go long).
Note that the support and resistance can come in different formats.
Other than horizontal support and resistance levels, you can use
technical tools like Fibonacci, trendlines, pivots, channels etc.
The key point here is…
Place the stop-losses either above or below them, but not on them.
Failure to do this means that a false breakout will trigger your stop and you will be left with a loss.
#2: Use Trailing Stops in Strategies Following Trends
Trailing stop losses are the type of stop-loss orders that trail the price with every tick that favors you.
This means that they keep on moving the stop-loss level automatically.
However, in case it happens that the price reverses and begins to go against you, the trailing stop will stay at its most recent level, helping you limit your losses or lock in the unrealized profits.
Let’s see how a trailing stop-loss order works…
In the above chart, the trader made a purchase and set an amount for the trailing stop loss order.
The price then moved in a direction that favors him.
Suddenly, the price reversed, moving against him.
The trailing stop-loss order will be triggered once the price moves against him by the pre-specified amount.
The trade will then be closed, preventing the trading from incurring any further loss!
Because of the nature of how they work, they are popular among traders who follow trends.
To apply a trailing stop on a strategy that follows a trend, simply measure the average distance between the higher low and the higher high (for uptrends) and lower highs and lower lows (for downtrends).
This way, you will set a trailing stop whose distance will be the correction move of a trend.
In the above chart, we are having a downtrend.
That’s why we’re measuring the average distance between the lower highs (LH) and the lower lows (LL).
The distance of the stop loss order becomes equal to the correction move of the trend.
With such an approach, you’ll remain inside the trend as long as possible, or until the trend reverses.
The trailing stop will also lock-in profits on the way!
#3: Move Stop Losses to Lock-In Profits
This is another risk management technique in which you lock in the unrealized profits simply by moving your stop-loss level in a profitable trade.
This technique gives a similar result like when using a trailing stop, with the difference being that the stop loss is moved manually.
There are advantages as well as disadvantages associated with this.
For example, since the stop loss is moved manually, you’ve more control over the timing of your move.
However, you may give back unrealized profits in case the price reverses before you move your stop loss.
Most traders using this technique follow a percentage system, that is, they move their stop loss to breakeven after the profit hits 33% of the take profit, move the stop loss to 33% once the profit hits 66% of the take profit, etc.
#4: Calculate your Position Size Depending on your Stop Loss
You must include position sizing in your trading and risk management plan.
It’s a common mistake made by newbie traders, and without using the position sizing, you increase chances of blowing your account.
Position sizing involves calculating your position relative to the risk that you are taking.
Stop losses are important when doing this calculation.
Suppose you’ve placed your stop-loss 50 pips away from the entry price, depending on an important support or resistance level, that is, a chart stop.
You only want to risk 2% of a $20,000 trading account, which equals to $400.
You should trade a position size that returns a pip-value of $8, that is, $400 / 50 pips.
What does this mean?
It means that for each pip that the price moves in your favor, your profits will rise by $8, and vice-versa.
One standard lot, i.e, 100,000 units of the base currency, has a pip-value of $10.
In our example, you should open a position size of 0.80 lots.
However, every currency pair has different pip-values.
That’s why most popular trading platforms will allow you to fine-tune your position size to meet the pip-value that you desire.
#5: Use a Wider Profit Target than the Stop Loss
A successful trader expects to make a larger profit than his potential loss.
In short, such a trader will risk $1 to get back $3, $4 or even $5.
This is referred to as the reward-to-risk ratio of a trade.
For example, let’s say you place both your stop-loss and take-profit levels 50 pips away from your entry price.
The trade will have a reward-to-risk ratio of 1.
This can be interpreted as, you’re risking $1 to make $1.
This may have a negative effect on your trading performance in the long run.
The reason is that you should record a success rate of above 50% in order to make a profit.
Suppose you place your stop-loss 50 pips away and a take profit of 200 pips. This means your reward-to-risk ratio is 4:1. This can be translated as…
You are risking $1 to make $4.
With such an approach, it means that you can make profit even with a success rate of below 50%.
The take-profit orders, just like the take-profit orders, should be based on the important technical levels.
Just place your take-profit some pips above an important support (if your plan is to go short).
The reason is that you don’t want a situation where the price reverses before your take-profit is triggered.
From the above discussion, it’s very clear that stop-loss orders can play a significant role in your trades!
Conclusion:
- The stop-loss order is an important tool that every serious trader should learn.
- Stop-loss orders are good risk management tools for traders.
- They help traders state the amount of loss that they are ready to tolerate.
- If the price hits your pre-determined level, it closes the losing position.
- A stop-loss is better than a mental stop.
- The more you practice, the easier it will become for you to add stop-loss orders to your trades.
- A stop-loss order will protect you from the volatile forex market.
- If you find yourself trading emotionally, use a stop-loss order.