Stop Loss? What's That?

Let's face it. The market will always do what it wants to do, and move the way it wants to move. Every day is a new challenge, and almost anything from global politics, major economic events, to central bank rumors can turn currency prices one way or another faster than you can snap your fingers.

This means that each and every one of us will eventually take a position on the wrong side of a market move.

Being in a losing position is inevitable, but we can control what we do when we're caught in that situation. You can either cut your loss quickly or you can ride it in hopes of the market moving back in your favor.

Of course, that one time it doesn't turn your way could blow out your account and end your budding trading career in a flash.

The saying, "Live to trade another day!" should be the motto of every trader on Newbie Island because the longer you can survive, the more you can learn, gain experience, and increase your chances of success.

This makes the trade management technique of "stop losses" a crucial skill and tool in a trader's toolbox.

Having a predetermined point of exiting a losing trade not only provides the benefit of cutting losses so that you may move on to new opportunities, but it also eliminates the anxiety caused by being in a losing trade without a plan.

Less stress is good, right? Of course it is, so let's move on to different ways to cut 'em losses quick!

Now before we get into stop loss techniques, we have to go through the first rule of setting stops.

Your stop loss point should be the "invalidation point" of your trading idea.

When price hits this point, it should signal to you "It's time to get out buddy!"

In the next section, we'll discuss the many different ways of setting stops.

There are four methods you can choose from:

1.     Equity stop

2.     Volatility stop

3.     Chart stop

4.     Time stop

Ready? Let's get started!

Equity Stop

Let's start off with the most basic type of stop: the equity stop.

This is also known as the percentage stop because it uses a predetermined portion of the trader's account, say 2%, that a trader is willing to risk on a trade.

The percentage risk can vary from trader to trader -more aggressive ones risk up to 10% of their account while less aggressive ones usually have less than 2% risk per trade.

Once the percentage risk is determined, the trader uses his position size to compute how far he should set his stop away from his entry.

This is good right?

A trader is putting a stop, which is in accordance with his trading plan.

This is good trading right?

WRONG!!!

You should always set your stop according to the market environment or your system rules, and not how much you want to lose.

We bet you're thinking right now, "Huh? That doesn't make any sense. I thought you said that we need to manage risk."

We agree that this sounds confusing, but let us explain with an example. You remember Newbie Ned from your Position Sizing lesson don't you?

Newbie Ned has a mini account with $500 and the minimum size he can trade is 10k units. Newbie Ned decides to trade GBP/USD, as he sees that resistance at 1.5620 has been holding.

As per his risk management rules, Ned will risk no more than 2% of his account per trade.

At 10k units of GBP/USD, each pip is worth $1 and 2% of his account is $10. So, the largest stop Ned can put on is 10 pips, which is what he does on this trade by putting his stop at 1.5630.

But GBP/USD moves over 100 pips a day! He could easily get stopped out at the smallest move of GBP/USD. Because of the position limits his account is set to, he is basing his stop solely on how much he wants to lose instead of the given market conditions of GBP/USD.

Let's see what happens next.

And bam! Ned got stopped out right at the top, because his stop loss was too tight! And aside from losing this trade, he missed out on a chance to grab over 100 pips! 

From that example, you can see that the danger with using equity stops is that it forces the trader to set his stop at an arbitrary price level.

Either that stop will be located too close to entry, like in Newbie Ned's case, or at a price level that doesn't take technical analysis into account.

For all you know, you could be setting your stop right at that level where the price could turn and head your way (who hasn't seen that before?). But because you already got stopped out, you wouldn't be able to bag those pips! Darn it!

The solution for Ned is to find a broker that suits his trading style and starting capital.

In this case, Ned should trade with a broker that allows him to trade micro or even custom lots. At 1k of GBP/USD, each pip is worth $0.10.

In order for Ned to stay within his risk comfort level, he can set a stop on GBP/USD to 100 pips before losing 2% of his account. He now has the ability to set his stop to the market environment, trading system, support & resistance, etc.

Chart Stop

A more sensible way to determine stops would be to base it on what the charts are saying.

Since we're trading the markets, we might as well base our stops on what the markets are showing us... Makes sense, right?

One of the things that we can observe in price action is that there are times when prices can't seem to push or break beyond certain levels.

Often times, when these areas of support or resistance are retested, they could potentially hold the market from pushing through once again.

Setting stops beyond these levels of support and resistance makes sense, because if the market does trade beyond these areas, then it is reasonable to think that a break of that area will bring in more traders to play the break and further push your position against you.

Or, if these levels DO break, then there may be forces that you are unaware of suddenly pushing the market one way or another.

Let's take a quick look at a way to set your stops based on support and resistance:

On the chart above, we can see that the pair is now trading above the falling trend line.

You decide that this is a great breakout trade setup and you decide to go long.

But before you enter you trade, ask yourself the following questions:

Where could you possibly set your stop?

What conditions would tell you when your original trade idea is invalidated?

In this case, it makes the most sense to set your stops below the trend lines and support areas.

If the market moves into these areas, that means the trend lines drew no support from buyers and now sellers are in control.

Your trade idea was invalidated and it's time you to suck it up, exit the trade, and accept the loss.

If you want a real life example, take a look at Huck's trend line play on EUR/USD!

Volatility Stop

To put it in simple terms, volatility is the amount a market can potentially move over a given time.

Knowing how much a currency pair tends to move can help you set the correct stop loss levels and avoid being prematurely taken out of a trade on random fluctuations of price.

For instance, if you are in a swing trade and you know that EUR/USD has moved around 100 pips a day over the past month, setting your stop to 20 pips will probably get you stopped out too early on a small intraday move against you.

Knowing the average volatility helps you set your stops to give your trade a little breathing room and a chance to be right.

As we explained in a previous lesson, one way to measure volatility is by using Bollinger Bands. You can use Bollinger bands to give you an idea of how volatile the market is right now.

This can be particularly useful if you are doing some range trading. Simply set your stop beyond the bands. If price hits this point, it means volatility is picking up and a breakout could be in play.

Another way to find the average volatility is using the Average True Range (ATR) indicator. This is a common indicator that can be found on most charting platforms, and it's really easy to use.

All the ATR requires is that you input the "period" or amount of bars, candlesticks, or time it looks back to calculate the average range. 

For example, if you are looking at a daily chart, and you input "20" into the settings, then the ATR indicator will magically calculate the average range for the pair over the past 20 days.

Or if you are looking at an hourly chart and you input 50 into the settings, then the ATR indicator will show you the average movement of the last 50 hours. Pretty sweet, huh?

This process can be applied by itself as a stop or in conjunction with other stop loss techniques.

The point is to give your trade enough breathing room for fluctuations here and there before it heads your way... and hopefully it does.

Time Stop

Time stops are stops you set based on a predetermined time in a trade. It could be a set time (open limit time of hours, days, weeks, etc.), only trade during specific trading sessions, the market's open or active hours, etc.

For instance, let's say you are an intraday trader and you've just put on a long trade on EUR/CHF and it hasn't gone anywhere. We're talking real snoozeville here!

Why keep your money locked up in this trade when you can use it to take advantage of this one...

More movement, more pips! Yeah baby!

Because of your predetermined rules and the fact you do not like to hold trades overnight you have decided to close the position at 4:00 pm, when you're usually done for the day and go off to your bi-weekly StarCraft 2 tournament.

Or maybe you are a swing trader and you decided to close your positions on Friday to avoid gaps and weekend event risk.

Also, having some margin tied up in a dead trade could be costing you an opportunity in another great trade setup somewhere else.

Set a time limit and cut off that dead weight so that money can do what it is meant to do... Make more money!

Top Usage Mistakes

In this section, we'll talk about the common mistakes traders make when using stops. Sure, it's one way to practice proper money management but when used incorrectly, it could lead to more losses than wins. And you don't want that, do ya?

Placing Stops too tight

The first common mistake is placing stops tighter than those leather pants that Big Pippin used to wear back in the retro days. They're so tight that there ain't no room to breathe!

In placing ultra-tight stops on trades, there won't be enough "breathing room" for the price to fluctuate before ultimately heading your way.
Always remember to account for the pair's volatility and the fact that it could dilly-dally around your entry point for a bit before continuing in a particular direction.
For instance, let's say you went long GBP/JPY at 145.00 with a stop at 144.90. Even if you are right in predicting that the price would bounce from that area, it's a possibility that the price will still dip 10-15 pips lower than your entry price before popping higher, probably until 147.00.
But guess what? You weren't able to rake in a 200-pip profit because you got stopped out in a jiffy.
So don't forget: Give your trade enough breathing room and take volatility into account!

Using position size as a basis for stops

We've mentioned this earlier in the lesson already: Using position size instead of technical analysis to determine stops ain't such a good idea. We learned that from Newbie Ned, remember?
As we discussed, using position sizing to calculate how far your stop should be has nothing to do with how the market is behaving. Since we're trading the market, it'd make much more sense to set stops depending on how the market moves.
After all, you picked your entry point and targets based on technical analysis so you should do the same for your stop.

We're not saying that you should forget about position size completely. What we're recommending is that you should decide where to place your stops first BEFORE calculating your position size.

Placing stops too far

Some traders make the mistake of setting stops way too far, crossing their fingers that price action will head their way sooner or later.
Well, what's the point of setting stops then? What's the point of holding on to a trade that keeps losing and losing when you can use that money to go for a more profitable one?
Setting stops too far increase the amount of pips your trade needs to move in your favor to make the trade worth the risk.
The general rule of thumb is to place stops closer to entry than profit targets.
Of course you'd want to go for less risk and bigger reward, right? With a good reward-to-risk ratio, say 2:1, you'd be more likely to end up with profits if you're right on the money with your trades at least 50% of the time.

Placing stops exactly on support/resistance levels

Setting stops too tight? Bad. Setting stops too far? Bad. Where exactly is a good stop placed then? Well, not exactly on support or resistance levels, we can tell you that.
How come? Didn't we just say that technical analysis is the way to go when determining stops?
Sure, it's helpful to note nearby support and resistance levels when deciding where to place stops.
If you're going long, you can just look for a nearby support level below your entry and set your stop in that area.
If you're going short, you can find out where the next resistance level above your entry is and put your stop around there.
But why isn't it a good idea to put it right smack on the support or resistance level?
The reason is that the price could still have a chance to turn and head your direction upon reaching that level. If you place your stop a few pips beyond that area then you'd be more or less sure that the support or resistance is already broken and you can then acknowledge that your trade idea was wrong. 

How to Execute Stops

Once you've done your homework and created an awesome trade plan that includes a stop out level, you now have to make sure that you execute those stops if the market goes against you.

There's two ways to do that. One is by using an automatic stop and another through a mental stop.

Which one is best suited for you?

Here's where the hard part comes in as the answer to this question lies in your level of discipline.

Do you have the mental toughness and self-control to stick to your stops?

In the heat of battle, what often separates the long-term winners from the losers is whether or not they can objectively follow their predetermined plans.

Traders, especially the more inexperienced ones, often question themselves and lose that objectivity when the pain of losing kicks in and brings in negative thoughts like, "Maybe the market will turn right here. I should hold a bit longer and then it will go my way."

Wrong!

If the market has reached your stop, your reason for the trade is no longer valid and it's time to close it out... No questions asked!

This is why the almighty forex gods invented limit orders. New traders should always use limit orders to automatically close out a losing trade at predetermined levels.

This way you won't give yourself the chance to doubt your plan and make a mistake. You won't even have to be sitting in front of your trading station to execute the order.

How awesome is that?!

Of course, the more trades and experience you have under your belt, the more you will hopefully have a better understanding of market behavior, your methods, and the more disciplined you will be.

Only then would mental stops be okay to use, but we still HIGHLY recommend limit orders to exit the majority of your trades.

Manually closing trades leaves yourself open to making mistakes (especially during unforeseen events) such as entering the wrong price levels or position size, a power outage, a coffee binge induced bathroom marathon, etc.

Don't leave your trade open to unnecessary risk so always have a limit order to back you up!

Because stops are never set in stone and you have the ability to move them, we will end this lesson with the "do's and don'ts" of moving your stop.

1. Don't let emotions be the reason you move your stop. Like your initial stop loss, your stop adjustments should be predetermined before you put your trade on. Don't let panic get in the way!
2. Do trail your stop. Trailing you stop means moving it in the direction of a winning trade. This locks in profits and manages your risk if you add more units to your open position.
3. Don't widen your stop. Increasing your stop only increases your risk and the amount you will lose. If the market hits your planned stop then your trade is done. Take the hit and move on to the next opportunity. Widening your stop is basically like not having a stop at all and it doesn't make any sense so to do it! Never widen your stop!

These rules are pretty easy to understand and should be followed religiously, especially rule number 3!

Want us to repeat it again?

DO NOT WIDEN YOUR STOP!

Always remember to plan your trade ahead and figure out what to do in each scenario so that you won't panic and do something you'd probably regret later on.