A Guide to Stop Loss Placement.
Where to place our stop loss can be as complicated as you make it. Lots of traders try to get too cute with placing their stop losses and this is where some traders can become unstuck. Giving trades the right amount of space to breath is very important. We cannot expect the market to move continuously in one direction and so we have to be prepared for price to reverse when we are in a trade.
The use of stop losses plays a vital role in protecting ourselves from large losses in the forex markets, to trade without stop losses would be very risky indeed.
We also use stop losses to establish the amount we want to risk per pip on each trade.
So say we had a 100 pip stop loss and wanted to risk £500 on the trade, we would open a position that risks £5 per pip.
Now a lot of traders get put off using large price action candles to trade from because the stop losses will be large. This shouldn’t be the case, we just need to reduce the amount risked per pip to compensate for the larger stop.
So if the stop loss was 200 pips and again we wanted to risk £500 we would instead open a position that risks £2.50 per pip.
The simplest way to choose your stop loss placement before entering a trade.
Now I use a very simple method and it involves asking ourselves before we enter a trade, “where if price does manages to reach a certain level will the chances of price continuing against us be high”
Usually, I would say the range of the price action setup candle is a good place for our stop loss. So if we are going short off a price action candle the high is the logical place to put our stop loss. This will give the trade the room to breath.
If price did manage to break through the high of the price action setup, the chances price will continue on up is very high and so I am happy to be out of the trade but also knowing I have given the trade the most space possible to see if it can work out.
However, if the price action setup candle is extremely large in size, placement of our stop loss using the range maybe too much. Very large price action candles indicates large strength and momentum, so after a very large candle forms price can do two things:
1. Continue on in the direction of the momentum.
2. Due to the largeness in size of the price action candle and the distance price has moved in a short space of time, price may instead reverse as traders close their trades to take some profits. This allows the traders who missed the boat the first time a chance to jump onto the trade with a retracement of price back to value.
Therefore, if after a very large candle forms and we do see price retrace we need to ask ourselves where will price most likely get to and then get rejected strongly. The answer for me would be at a key level.
If a price action candle, very large in size has a key level within its range, that key level should have a strong chance of repelling price back in the desired direction. So hiding our stop loss in this area makes sense.
I tend to avoid putting a stop loss any lower than the 61% fib retracement level of any price action candle though, as I feel reducing the stop loss any more is too risky and does not allow enough space for price to breath. Even if a key level sits around the 38.2% fib retracement, I will still keep the stop loss beyond the 61% fib.
Does the trend matter?
A factor that can also help us in placing our stop loss is what the current trend or momentum is. If we are intending on taking a trade with the current momentum then it seems logical to assume we can be a little more aggressive on the stop loss placement.
Taking trades against the current momentum (counter trend trades) is more like trying to swim against the tide, the chances of more chop and resistance is much higher and we should be prepared for a rockier ride. Therefore, the chance that price will go sideways or retest a key level is much higher and so using an aggressive stop loss will not allow the trade the space to breath.
Thus, stop loss placement must involve the use of logical levels to help us make our decisions. If we are unable to determine a key level that maybe used to reduce the stop loss then the candle range is to be used.
Most of the time I use the range to place my stop loss but if we get a really large candle and a logical place to hide the stop loss, I will do so. Remembering to factor in the current momentum as a point to consider.
Stop Loss Management.
Once we get into a trade and it moves off nicely from our entry point the next question we have to ask ourselves is, when do we get to break even and how do we trail the stop loss to lock in profits?
Moving to break even.
The first thing we need to decide is when to get a trade to break even, I personally like to do this as soon as the first trouble area is hit (Check out the article “Why do trades reverse against us?”). The reason being I’d much prefer to be taken out of a trade at break even rather than have a full loss. If we ignore the possibility a trade has the potential to reverse against us, we expose ourselves to a lot of losing trades.
Some traders ignore the first trouble area or don’t even know it’s there but I truly value this information and it will definitely reduce the number of full losses you incur.
Stop Loss trailing.
Now locking in profits is always going to be an area you feel you can do better in but remember there is no technique out there to lock in every single pip on every trade, it’s just not possible. So beating yourself up if a trade moves another 500 pips without you, after your stop loss gets hit is pointless.
If you stick to your trade plan which you decided before entering the trade, you can do no more and you should be proud of yourself for having the discipline to follow the plan through.
The options for trailing stop losses are many and varied, I will go through a few to give you some ideas, but this is all down to personal preference.
1. Two bar trailing stop loss, now this is a simple technique whereby you place your stop loss, 2 bars behind the current candle. It is very effective with trend trades and can keep you in trades to get those runners.
2. Using the most recent swing points, again this is a simple technique where you use the most recent swing points to hide your stop loss. This is for the braver trades who can handle price pulling back large distances against them.
3. Using the most recent levels broken to hide a stop loss. This being my personal favourite.
4. There is also an option to use price action to help us with stop loss placement.
An example here would be if we were short on a pair and a large bullish engulfing bar (BUEB) formed, now we know if the bar is large it could result in price continuing against our short position. Therefore, a simple way to cover our trade is to place the stop loss just above the high of the BUEB. The reason being if price does manage to break higher from the BUEB we get taken out and lock in some profit. This type of stop loss placement modification needs to be used with strict rules though. Making sure we only modify our stop loss if the reversal setup is large and valid, this is not to be used on tiny weak price action setups.
It’s down to you!
How we manage our stop loss trailing will have a direct impact on how much profit we can take off the table. I like to be more conservative with my stop losses and take profits and so am happy to have smaller yet more consistent profits rather than hoping for those illusive runners that are so attractive to so many traders.
I hope this may have given you some ideas on where and how stop losses can be placed. Unfortunately, there is no single method to handle placement and trailing of stop losses, it all comes down to what works best for your own personal trading.
An important note, is to decide all of this prior to entering trades. Making decisions about placement and trailing of stop losses on the hop whilst in a trade is never going to produce consistent results and just gives you an unnecessary trading headache.