Hi there everyone,
Thank you all for your comments and responses to last week’s article on stop losses! I am so glad that everyone learned so much from it and was happy to read the positive feedback.
As promised last week I am now going to share the second part on the “ultimate guide on stop losses”, which will provide a more practical indication and view for placing stop losses.
1) Always trade with a stop loss – protect yourself;
2) Define your own stop loss and always define it before you enter the trade;
3) Never move your stop loss unless absolutely necessary.
Today’s article will be fully focusing on point 2, the stop loss placement.
In the first part, we will look at the topic from all kind of angles, including how the type of strategy, the structure of the market, key levels, time factor, a trader’s character and psychology determine and influence stop loss placement.
In part 2 the article will divulge and analyze various FX technical analysis tools and how they can help with Stop Loss placement.
1) Factors to analyze
a) Strategy choice
The Forex strategy is very important for any trader’s stop loss decision making process. For example, if you are a trader which is seeking to trade with the trend, then using Fibonacci levels could be very important for you. If you are trader that likes trading in range and huge consolidation zones, then key market levels are something that you want to keep an eye on because the Fib levels might have less importance. More on that in Part 2!
b) Market structure
Basically reading the structure of the market is important when determining the stop loss reliability. When the market is choppy and moving violently up and down with lots of volatility, the trader wants to adopt the choice of the stop loss position. Or if the market is correcting itself in a slow and choppy manner, the stop losses are less secured. We can use a bear or bull flag pattern as an example. In a bull flag, the bottoms do not tend be very secure places for stop losses unless you are certain of the turn, as there is always a chance that the market could correct the bull flag lower. If the market is moving in waves but with a clear structure, the stop loss placement becomes less tricky and using tops and bottoms becomes more secure.
c) Trading psychology and character
It really does not matter that much if traders trade with small or huge stop losses, it all depends if we have the psychology to execute the trading plan. We must choose a strategy in which we feel comfortable with our stop loss placement.
d) Time factor
The odds of a trade developing into a winning trade decrease if a trade takes too long to develop in relationship to a relatively tight stop loss. In my testing of time factor on the charts, I noticed a correlation between time and impulsive moves.
The correlation I noticed was that price should continue impulsively in the direction of my trade within a few candle sticks, otherwise the likelihood of a substantial pause in time or a bigger correction in pips is high. Of course there are exceptions to the rule, but in most cases the time factor guidelines do indeed materialize. Please read here more about how time factor influences trading.
Part i) tight stops
It should be noted though that these assumptions are based on a tight stop loss. A tight stop loss is a stop loss level which hugs market action closely. An example is when a trader uses the chart of same time frame and the most recent bottom or top of the current swing high swing low. The spot is a decent place for a stop loss, but is in danger of being taken by the market if the trade does not move swiftly in the direction of the trade.
Part ii) loose stops
A looser stop loss which is not as close to market action as in the previous example would be exempt from these statistics. A looser stop loss would qualify when for example a support or resistance is used on a higher time frame or when a bottom or top is used which is further away from current market action.
Both a loose or tight stop loss has their advantages and disadvantages and both are reasonable options. It is the time factor which is a crucial aspect. We want to avoid giving the trade too much space in terms of time and too little space in terms of pip size. So either a tight loss which moves quickly in our favor, or a looser stop loss which we can give more time to develop. The market is an expert on retracing, finding, and taking out tight stop losses.
In the next pages we will analyze the FX technical analysis tools which will help us Forex traders with the placement of Stop losses.
2) Forex Technical analysis tools
a) Fibonacci retracement levels
Many Forex traders are using Fibonacci retracement levels for their FX trading. The Fibonacci numbers are well respected in the Forex market place, so using that knowledge and technical analysis tools to your advantage makes a lot of sense. The Fibs provide for great discount when trading. For example in a trend when the currency pulls backs from a recent move to a 500 Fib, it is basically the same as getting a 50% discount when shopping. Not something any trader wants to miss out on.
Of course there are things you need learn before actually using Fibs. You need to know how to Fib the correct swing high swing low for example, which is a vital and crucial element. But that is a whole different topic which we would need to explain in a different article. Let us know if you want to know more about Fibs in the comment section down below! Thanks 🙂
Sub I: Stop loss placement
In any case, Fibs give traders a fantastic place to hide their stop loss: under or above the swing high swing loss, or in other words, under or above the high / low of the move you are Fibbing. This is ALWAYS the safest stop loss area. And furthermore, when a trader puts their stop loss above or under an extreme (high or low), the trader will always be right. Why is that you might wonder?
Sub II) why you are always correct
The currency loves to make many waves up and down. And a bounce off the 500 Fibo does not mean that the currency is going to hit your target in 1 shot. On the contrary, it most likely will make many ups and downs. It could actually retrace to a deeper Fib, such as the 618 Fib retracement level in this example, and later on still move in your direction. If a stop loss is placed in the middle of the Fib zone, then any trader just took an unneeded loss. With the stop loss under or above a high / low, the trade is always safe. If the stop loss does get taken out, then apparently the swing high swing low we used for Fibbing was the incorrect one and there was nothing we could have done to avoid that loss. In that case we need reevaluate our facts, assumptions and reasons for taking the trade. But the trade management side of the trade was correct.
SubI II) huge stop losses?
You might be asking yourself: the stop losses can be huge, what do I do? Yes sometimes the stop losses could be huge if the swing high or low is used. That is why some traders do use tighter stop losses on bigger charts, such as the 4 hour, day and week charts. Here are the choices:
* The trader can choose to place the stop loss behind the next big Fib. For example, if the currency is at the 382 Fib, the trader could place the Stop Loss behind the 500 Fib;
* Another method is to place the Fib behind the 618 Fib;
* The 786 Fib is another big level which is used for stop loss protection;
* Last but not least, traders use other methods for defining a good stop loss in combination with Fibs. Examples are support and resistance levels on the day chart, consolidation zones, chart patterns, trend lines, lower time frame Fibs, etc.
But we have the realize that we are trying to “cheat” 😉 These stop losses can work fine, but we have to be careful and really choose our levels well.
b) Tops and bottoms / fractals / swing high + swing lows
These are great spots for stop losses placement. Especially if a higher time frame chart is used. I am not saying that a 15 minute fractal would have no importance at all, but let’s face it: a day chart just has that extra impact on currency movements. Any top/bottom/fractal on the 4 hour, day chart and week chart are just great levels to keep in mind. Read here more about fractals.
c) Candle stick highs and lows
Candle stick highs can be pretty decent levels as well. Of course their significance is less substantial than a top, bottom, or fractal. But still, the levels are important to note. The biggest advantage is the stop loss size is usually smaller in comparison to using the fractal itself. Especially day candle highs and lows are decent resistance and support levels. In any case, as a trader you want to avoid shorting the market close to a previous day high and longing the market at previous day low.
d) Invalidation levels of the Elliott Wave (EW) Theory
If you are using the Elliott Wave Theory for your trading, then you know that the market offers certain price levels which invalidate your current EW count. That level would be the preferred choice of your stop loss because that is ultimately the place where your vision of the market proves to be incorrect.
I will give an example. Let us say you use a stop loss that is actually not at your invalidation level, then the market in theory could take your stop loss and turn to your desired direction without hitting your invalidation level. Your vision of the market structure could be correct, but the analysis would leave you penniless.
e) Consolidation zone / resistance – support areas / trend lines
Consolidations zones and support and resistance levels are just fabulous and great tools for giving that extra level of confidence for stop loss placement. These key levels on the day and week chart are of huge importance to the market and they could be used to keep the stop loss size in terms of pips small(er). Furthermore, the chances of the market actually pushing though these key levels in one try without any respect for the level is ultimately very small. The only exception could be an interest day announcement, a NFP day, or some unusual news event. Otherwise there is a high probability that the technical levels provide great support and resistance, and that is exactly what we as traders are looking for.
Part 3) stop losses versus risk + money management
a) money management
The stop loss size is important, because it is part of the measurement we use to calculate reward to risk. The stop loss size equals a number of pips, which represents our risk of course. Our reward is the target we are aiming for. The ratio between the two is the reward risk ratio. So assuming we aim for the same target, a smaller risk would equal an improved reward to risk ratio.
For example, the market circumstances show us a decent trade with a 45 pip stop loss under the fractal and our target is 90 pips away. That is a good 2:1 trade. We however detect some potential resistance on a lower time frame and decide to wait and attempt to catch a lower entry. The plan succeeds and we manage to lower our risk to a 30 pip stop loss. If we keep the target at 90 pips away, our reward to risk has increased from 2:1 to 3:1. That is a massive difference.
The other option a trader can use for this example is to keep that 2:1 reward risk ratio, even if the stop loss risk has been reduced. This has its own merits as well, because the chances of our trade developing and hitting our 60 pip target are higher than hitting our 90 pip target, usually speaking.
b) risk management
Of course the stop loss size in terms of pips has no influence on the risk percentage traders decide to take on any give trade. Regarding the actual risk of our trading capital, it does not matter if a trade has a 50 pip stop loss, or 100 pip stop loss, because a trader can adjust their lot size accordingly.
Let’s say a trader wants to risk 1% of their trading capital ($10k account for example). The trader would want to risk $100 (1% of 10,000). If the stop loss is 50 pips, a position size of 2 minis needs to be taken to risk 1%. If the stop loss is 100 pips, a position size of 1 mini needs to be taken. The risk on the trade remains the same in both cases!
The risk is always our choice! The only reason why minimizing our stop loss is important is because traders then have the opportunity to maximize reward to risk potential.
Great reading for this weekend!
Al righty folks, there is still tons of stuff I would like to share with you, but the article is becoming massive and very long so I think you deserve a break!
Congrats on finishing the article! Everyone deserves a certificate for a job well done 🙂 Thanks for your time and reading!
Here is some great reading material you definitely want to take a look at this weekend!
Simple Forex trading: impulses
Enemy number 1: Fear
Trading break outs: true or false?
The power of divergence
The power of momentum
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Good Trading and have a great weekend!
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