Trading can be considered a game of probability. This means that every trader will invariably get it wrong sometimes. When a trade goes bad, there are only two options: accept the loss and liquidate your position, or double down and possibly go down with the ship.
This is why the use of stop orders is so important. Many traders take profits quickly, but cling to losing trades; it’s just human nature. We take profits because it feels good and we try to hide from the discomfort of losing. A correctly placed stop order solves this problem by acting as insurance against too much loss. To work properly, a stop loss must answer a question: At what price is your opinion wrong?
In this article, we’ll explore several approaches to determining stop placement in forex trading that will help you swallow your pride and keep your portfolio afloat.
Key points to remember
- Stop orders are useful for any trading strategy to mitigate the risk of a bad trade turning into runaway losses.
- In order to use stops to your advantage, you need to know what type of trader you are and be aware of your weaknesses and strengths.
- Every trader is different and therefore stop placement is not a one-size-fits-all business. The key is to find the technique that matches your trading style.
The sudden stop
One of the simplest stops is the hard stop, in which you simply place a stop a certain number of pips from your entry price. However, in many cases, having a hard stop in a dynamic market does not make much sense. Why would you place the same 20 pip stop in both a calm market and a volatile market? Likewise, why would you risk the same 80 pips in calm and volatile market conditions?
To illustrate this point, let’s compare quitting to buying insurance. The insurance you pay for is a result of the risk you take, whether it’s a car, a house, a life, etc. One-year-old non-smoker with normal cholesterol levels because his risks (age, weight, smoking, cholesterol) make death more likely.
Stop method % ATR
The ATR % stop method can be used by any type of trader because the width of the stop is determined by the percentage of the Average True Range (ATR). ATR is a measure of volatility over a specified period of time. The most common length is 14, which is also a common length for oscillators, such as Relative Strength Index (RSI) and Stochastics. A higher ATR indicates a more volatile market, while a lower ATR indicates a less volatile market. By using a certain percentage of ATR, you ensure that your stop is dynamic and changes appropriately with market conditions.
For example, for the first four months of 2006, the average daily GBP/USD range was around 110 pips to 140 pips (Figure 1). A day trader may wish to use a 10% ATR stop, which means the stop is placed 10% x ATR pips from the entry price. In this case, the stop would be between 11 pips and 14 pips from your entry price.
A swing trader can use 50% or 100% of the ATR as a stop. In May and June 2006, the daily ATR was 150 pips to 180 pips. As such, the day trader with the 10% stop would have stops from the entry of 15 pips to 18 pips, while the swing trader with the 50% stops would have stops from 75 pips to 90 pips from the entry. ‘hall.
Image by Sabrina Jiang © Investopedia 2021
It makes sense for a trader to account for volatility with wider stops. How many times have you been stopped in a volatile market, only to see the market reverse? Getting stopped is part of trading. It will happen, but there’s nothing worse than being stopped by random noise, only to see the market move in the direction you originally predicted.
Up/Down over several days
The multi-day high/low method is best suited for swing traders and position traders. It’s simple and forces patience, but it can also be too risky for the trader. For a long position, a stop would be placed at the low of a predetermined day. A popular setting is two days. In this case, a stop would be placed at the two-day low (or just below).
If we assume that a trader was long during the uptrend shown in Figure 2, the individual would likely exit the position at the circled candle as it was the first bar to break below its two-day low . As this example suggests, this method works well for trend traders as a trailing stop.
Image by Sabrina Jiang © Investopedia 2021
This method can cause a trader to take on too much risk when making a trade after a day that has a wide range. This result is illustrated in Figure 3 below.
Image by Sabrina Jiang © Investopedia 2021
A trader who enters a position near the high of the large candle may have picked a bad entry but, more importantly, that trader may not want to use the two-day low as a stop-loss strategy because (as shown in the Figure 3) the risk can be significant.
The best risk management is a good entry. Either way, it’s best to avoid the multi-day high/low stop when entering a position right after a day with a wide range. Longer term traders may want to use weeks or even months as parameters for stop placement. A two-month low stop is a huge stop, but it makes sense for the position trader who only makes a few trades a year.
If the volatility (risk) is low, you don’t need to pay as much for insurance. The same goes for stops – the amount of insurance you will need for your stop will vary depending on the overall risk in the market.
Close above/below price levels
Another useful method is to set stops on closes above or below specific price levels. There is no real stop placed in the trading software; the trade is closed manually after closing above/below the specific level. The price levels used for the stop loss are often round numbers that end in 00 or 50. As in the multi-day high/low method, this technique requires patience because the trade can only be closed at the end. of day.
When you set your stops on closes above or below certain price levels, there is no chance of being knocked out of the market by stop hunters. The downside here is that you cannot quantify the exact risk and it is possible that the market will break out below/above your price level leaving you with a big loss. To combat the chances of this happening, you probably don’t want to use this type of stop before an important announcement.
You should also avoid this method when trading highly volatile pairs such as GBP/JPY. For example, on December 14, 2005, GBP/JPY opened at 212.36 then fell to 206.91 before closing at 208.10 (Figure 4). A trader with a stop loss on a close below 210.00 could have lost a lot of money.
Image by Sabrina Jiang © Investopedia 2021
Stop indicator
The indicator stop is a logical trailing stop method and can be used on any time frame. The idea is to get the market to show you a sign of weakness (or strength, if it’s short) before you break out. The main advantage of this stop is patience. You will not be shaken by a trade because you have a trigger that takes you out of the market. Just like the other techniques described above, the downside is greater risk. There is always a chance that the market will crash during the period when it crosses below your stop trigger.
In the long term, however, this exit method makes more sense than trying to pick a high to exit your long position or a low to exit your short position. How many times have you exited a trade because the RSI broke below 70, only to see the uptrend continue as the RSI hovered around 70? In Figure 5, we used the RSI to illustrate this method on a GBP/USD hourly chart, but many other indicators can be used. The best indicators to use for a stop trigger are indexed indicators such as the RSI, Stochastics, Rate of Change, or Commodity Channel Index.
Image by Sabrina Jiang © Investopedia 2021
The essential
With trading, you are always playing a game of probability, which means that every trader will be wrong sometimes. It is important for all traders to understand their own trading style, limits, biases and tendencies so that they can use stops effectively.
Investopedia does not provide tax, investment or financial advice and services. The information is presented without taking into account the investment objectives, risk tolerance or financial situation of any specific investor and may not be suitable for all investors. Investing involves risk, including possible loss of principal.
