Setting stop losses is an art, not a science. Traders whom can successfully master techniques and methods for placing them, will enhance their trading in more ways than they can imagine. While there are some traders whom do not use stop losses-and whom swear that stop losses are for bad traders-the Stop Loss Strategy is the key to long term survival and prosperity.
The fact is, even the best traders have bad trades. Humans, and yes even algorithmic traders can make errors. While some of the most studious traders will manually cut their losses-and stop losses might seem superfluous-there are times when the markets move so fast that they are not able to close trades at advantageous levels. This is also not an infrequent occurrence. Depending on the currency pair, liquidity can alter the dimension of speed so that traders can be shut out from closing trades. High speed traders whom manually enter and exit trades always face the danger that they cannot get in, and especially out in time when events move markets beyond their normal scope. This is a reason that most high speed traders will have automated Stop Loss Strategy. It’s simply too risky to trade without.
The challenge for most traders is how, and where to place stops. One of the most frustrating things about stop losses, is when they are triggered with great frequency. This can be a financial drain on a trader’s account, and a psychological strain on a trader’s confidence. Thereafter, many traders dispense with stops altogether, until the inevitable happens and they lose more money.
While the placement of stop losses can be tricky, it’s really more a matter of the approach one takes. Here are a few ideas:
Don’t place them in obvious locations. If you can see it, so can others. While there is no real way to “hide” a stop on a chart, traders don’t want to place them where there is a higher likelihood that price action will reach them. In one sense, traders want to hide in plain sight. In another sense, traders should keep in mind that price levels are targets for other traders. Indeed, the idea of the stop is prevent further losses on a trade where the price action has reached a point which could signal a reversal against the direction the trader has placed his or her trade. This is why it’s so difficult to place stops, especially for shorter term traders-scalpers and intraday traders-whom have targets at shorter distances and time intervals, and certainly don’t want to have too tight a stop, though at the same time need to balance risk against potential reward. Traders with less than a two to one of reward to risk often means that stops will be placed too close to the price action, and even small price spikes or swings can trigger the stop. A wider stance might accommodate the trading range, but could also compromise risk management. Hence the trader’s conundrum. The best stops...the ones that are less likely to be triggered...are those that are above or below KEY support and resistance levels. Also, if they have a bit of room above or below them, this solidifies the stop even more. Too often, traders will place stops on or too close to these levels. Price action will go through them a bit, and then reverse in the direction the trader had supposed, but only after taking out the trades. While stop loss strategy are primarily used to prevent deeper losses, they are also good as signals for trend reversals. This is particularly true for longer term traders, whom generally have much wider stops than the intraday or even the swing traders. The best trader will recognize when the trend has changed and be thankful that his or her stop limited his losses and alerted him to an opportunity to trade in the opposite direction when other signals confirm this.
Yes, they do hunt for stops. One usually hears this from the traders whom don’t use stops at all. They will say that the institutional traders hunt for the stops of the smaller retail traders, so why pay them (and your broker)? The reply to this is simple. Yes, there are stop hunters out there, and they probably know where the majority of traders have placed stops. Any experienced trader can read a chart and figure that out. However, this does not mean that the stop itself is to blame. It’s always the trader whom places the stop that has to be smarter. Indeed, most traders have experienced the type of loss that comes when a stop was triggered within a few pips of the limit of the move, only to see the trade go in the direction they chose and on to big profits. While this can add to the feeling of conspiracy, it is usually due to a trader not giving his or her trades enough space, especially in highly volatile markets. Traders need to learn that tight stops are not the answer. They can make the process of destroying an account slower, but the ultimate destination is often the same.
Going lighter gives your stops room to breathe. Given the choice between going lighter on the trade (less risk) and giving the trade some space for price action, OR going a bit heavier and less space, most experienced traders will go with the first option. The game is a long one, and the idea is to survive with most of your chips intact so that when they easy trades come, you will be there in the game and a winner. Tight stops might seem like a smart idea, but they generally work best for high speed automated trades where the profit target is measure in just a few pips. The manual trader should look for the best placement of stops first, and then adjust the risk level (the amount per bet or lots per trade) accordingly.
Risk reward ratio is more important than the stop. This goes “hand in hand” with setting the stop, and is the determining factor in overall profitability. Short trades for example, taken from, near or at KEY resistance levels, are always better bets, especially when the next support levels are two to three times the distance. Moreover, stops can be tightened a bit more than on “open terrain” devoid of key support and resistance levels. The risk reward ratio should always be a trader’s priority in evaluating potential trade setups. When the reward-and traders need to be realistic about how or why price action would move to this potential area-is much greater than the risk, the trade becomes almost a “no brainer.” The hardest part for most traders is having the patience to wait for these trades.
At the minimum, have an emergency stop. There are a few cowboys out there whom have managed to trade without stops. They are likely to brag about this and disparage other traders as “wimps” whom are just making their brokers rich. The truth is, many of these Alpha types have last ditch stops on their trades so that if things really go wrong, or if they are away from their trading terminals when they do (or their smartphones), the trade won’t wipe them out. We’ll let them think we don’t know the real deal, but emergency stops...which are usually placed at levels calculated at how much the trader can lose and still trade his or her account...are a great idea. As with cowboys, you don’t want to fall off your horse.
Don’t forget to place take profit limit too. The flip side of placing a stop loss, is also having an exit strategy. By placing a profit limit, you are more likely to have completely analyzed the trade from either a fundamental and/or a technical perspective, and not left it to chance. Nothing hurts than being in profit, having hit or passed the target you thought about placing, only to have the trade reverse. Even worse is when you were in profit and that trade reverses through your stop. That’s a double kick in butt. Too many of those types of trades, and you could be sidelined for a long time.