Stop losses not only help you limit your losses and help you move on, they also eliminate the anxiety caused by losing on an unplanned trade.
4 Types Of Stop Losses
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:
- Percentage stop
- Volatility stop
- Chart stop
- Time stop
Ready? Let’s get started!
How To Set A Stop Loss Based On A Percentage Of Your Account
Let’s start off with the most basic type of stop: the percentage-based stop loss.
The percentage-based stop uses a predetermined portion of the trader’s account. For example, “2% of the account” is what 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 1% risk per trade.
Once the percentage risk is determined, the forex 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?
You should always set your stop according to the market environment or your system rules, 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.
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 percentage stops is that it forces the forex 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 forex 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 could set a stop on GBP/USD to 100 pips before losing 2% of his account.
The math: 100 pips x $0.10 = $10.
How To Set A Stop Loss Based On Support And Resistance From Charts
The previous lesson discussed how to set stop loss using a percentage-based amount of your account.
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 your 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.
Example: Short EUR/USD
In the chart below, the EUR/USD has been trending down. Price has hit the falling trendline a couple times which makes for a nice resistance level.
You could place a short order right at the downtrend line (1.3690).
Now, where you would you place your stop loss?
Your stop loss would be placed at 1.3800.
Notice how this is above the resistance area: the falling trendline.
Let’s set profit targets at 1.3530 and 1.3450.
The trade is triggered. The trendline holds as resistance and price falls.
Your first profit target is hit. The second profit target is missed by a single pip but by that time, you had moved your stop loss to breakeven (where you entered short) so you lost nothing.
This is an example of using resistance as a guide on where to place your stop instead of simply using a fixed number.
How To Set A Stop Loss Based On Price Volatility
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.
Method #1: Bollinger Bands
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.
Method #2: Average True Range (ATR)
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.
How To Set A Stop Loss Based On A Time Limit
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 poker 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!
4 Big Mistakes Traders Make When Setting Stops
Let’s talk about the four biggest mistakes traders make when using stop losses.
We always stress using proper risk management but when used incorrectly, it could lead to more losses than wins. And you don’t want that, do ya?
1. Placing stops too dang 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 example, 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:
So don’t forget: Give your trade enough breathing room and take volatility into account!
2. Using position size like “X number of pips” as a basis for stops.
Using position size like “X number of pips” or “$X amount” instead of technical analysis to determine stops is a BAD idea.
We learned that from Newbie Ned, remember?
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.
3. Placing stops too far or too wide.
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 enter a more profitable trade?
Setting stops too far increases 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.
4. Placing stops exactly on support or 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.
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.
3 Rules To Follow When Using Stop Loss Orders
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 are 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.”
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 forex 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 3 rules to follow when using stop loss orders.
3 Rules of Setting Stop Losses
Rule #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!
Rule #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.
Rule #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!
DO NOT WIDEN YOUR STOP!
Or you will end up like this guy.
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.
Summary: Setting Stops
Now let’s review the things you need to remember about stop losses.
Find a broker that allows you to trade position sizes that suits the size of your capital and risk management rules. We use the word “predetermined” a lot in this lesson because you should ALWAYS know when to get out before you open a position.
Once you are already in a trade and it’s turned into a loser, you lose the ability to make a decision to exit the trade with a clear head. That could be very bad for your account balance! Set stops to the current market environment, framework, or trading method.
Do not set your exit levels to how much you are willing to lose.
The market does not know how much you have or how much you’re willing to lose. Quite frankly, it doesn’t care.
Find the stop levels that prove your trade wrong first and then manage your position size according to it.
This is worth repeating…
Use limit orders to close out your trade. Mental stops should only be used by those with a bazillion trades recorded in their journal.
Even then, limit orders are still the way to go: emotionally unbiased and can be automatically executed while you are taking in some sun on the beach and sipping on virgin margaritas.
Only move your stop in the direction of your profit target. Trailing stops are good, widening stops are very, very bad! Like anything else in trading, setting stop losses is a science and an art.
Markets are dynamic, volatility is well… volatile, and a rule or condition that works today may not work tomorrow.
If you continually practice the correct way to set stops, record and review your thought processes and trade outcomes in your journal, then you’ll be one step closer to becoming a professional risk manager!