The Ultimate Guide On Stop Losses

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Hi there everyone,

Today’s article topic is on Stop Losses. The subject is of immense importance to any Forex trader. Why? Simply put, the stop loss level is the ultimate level where a trader chooses to accept a losing trade. Stop losses are however only a necessity because Forex traders use leverage to maximize the potential gains from the Forex market. We will start our article with a quick glance at leverage, since it is the reason/culprit why we Forex traders absolutely must use stop losses.

The business of Forex

To be honest, I would not be surprised if businesses are jealous of Forex traders because of their fast and easy access to so much the capital. Then again, the high leverage is not given and granted to Forex traders because banks like us so much. Why can Forex traders have the access to the such high levels of leverage?

It is a simple business proposition for them. The higher the leverage the riskier the trading becomes. The riskier the trading is, the higher the likelihood of capital loss for the trader.

Traders are actually able to access very high levels of leverage. Typically anything from up to 100:1 is very common and nowadays the leverage “mania” continues and some brokers are even offering leverage levels close to 1000:1.

Leverage is the risk

Leverage is what makes the Forex business risky. Think about it. If you actually own currency, would you get stopped out? Would there be a need for a stop loss? The answer of course is no.

When you own the currency, you own it. The risk you run is the devaluation of that particular currency versus other currencies. You also run the risk of inflation and that the currency amount you own has less purchasing power in the future. But that is it. Owning and trading your currencies at a 1:1 rate is not that dangerous in fact.

The key difference is when you add leverage to the mix. Using leverage is a risky business. If you use leverage and you do not use a stop loss, you are gambling and you are in risk of losing all your capital and getting a margin call. The risk disclaimers are there for a reason, not just for the formality. The warnings are not nonsense. The lower the leverage the better, as the expectancy rate of your capital surviving and sustaining any string of losses increases.

With leverage the game is simple: you need to use a stop loss to protect your entire capital or trading capital.

The stop loss problems

Without any doubt, a stop loss is a must. But because you must use a stop loss to protect your (trading) capital, you do run a different risk. You run the risk of your stop loss getting hit and your trade taken out. Even if you have the best price entry in the world, there is always that chance where the market takes out your stop loss and then goes in the direction which you anticipated. There is nothing we can do about that. This is a fact of life and trading.

What we traders must do and the only thing we can do is find the best return to risk ration opportunities that succeed often enough. Or in otherwise these trade opportunities create on average a positive expected rate or return in the long run.  Another thing traders can do is find the best place for their stop loss in comparison to their type of strategy, the structure of the market, key levels, time factor, a trader’s character &psychology, etc. More on that later on.

Stop losses

The first I thing I did when I was preparing myself for this article is to look through the Winners Edge Trading website. There just so many cool articles and I could not stop reading. When browsing and reading I bumped into an article from Nathan who mentioned 3 rules of using stop losses.

The rules are:

1) Always trade with a stop loss – protect yourself;
2) Define your own stop loss and define before you enter the trade;
3) Never move your stop loss unless absolutely necessary;

Read here the entire article called “3 rules for using a stop loss”. I will add an easy checklist which you can print out and use.

Checklist

When it comes down Forex trading, everything needs to be prepared. A famous Forex expression is to plan our trade and trade our plan. Here are some crucial aspects every trader needs to have in their FX trading plan:

1. Plan your trade before you enter
2. Use hard stops, even if you have a soft stop
3. Don’t exaggerate with the leverage levels and try to minimize it
4. Use adequate stop loss sizes in relationship to realistic reward potential of your trading style;
5. Trade with sufficient Reward to Risk ratios in comparison to your win, break even, and loss percentages;
6. Stick to your plan after the trade begins: take profits as planned and never increase the stop loss size.

Stop losses = sensitive topic

Basically, the entire topic is a very sensitive matter for traders because simply put, the stop loss has the potential to cause the actual loss. Therefore there could be the temptation to do something no trader should ever do: to move the stop loss. Stop losses can bite.

Read more about stop losses and how difficulties associated with it in this article: “stop losses risk management in Forex trading.”

Many a trader has gone through the experience of the phenomena where there stop loss gets hit, after which they see the market reverse back into their direction without them. Read here a personal story from Nathan, the exact same thing happened to him and he write a very honest article about in “why good trades lose”.

Another thing that can happen is that the trade barely survives but after hours and hours of waiting, the trader decides to take off the trade, only then to see the currency finally move impulsively in the right direction. All traders have encountered this feeling and it is a rough experience. It is very demoralizing and it shatters the trader’s confidence. It can lead to a trader becoming fearful or reckless. The emotions which can be triggered are very real and dangerous and impede a trader from achieving success.

It does not matter how tempting it might be, once you have game plan, you must stick it. The temptation to ease the pain of a lose could overwhelming and the fear of losing might be tremendous, but whatever the psychological issues that emerge, don’t change the stop loss. It is ok to have a loose stop loss, as long as it fits the strategy setup you are using and you have planned it in advance.

So to sum it up, due to the leverage element of Forex trading, Forex traders must have a stop loss, we must define a stop loss level and we must never move our stop, however tempting that might be to avoid the pain of a losing trade. You will be setting yourself up for failure and run the risk of blowing up your account. Never forget that the first goal of Forex trading is to ensure the preservation of the trading capital. When the capital is lost, there is no trading day tomorrow or next week.

The big question: where to put the stop loss?

Forex trading will always create losses. That is the nature of the market and nothing we do will change that. However, traders are not helpless. There are definitely aspects a trader must consider to improve the quality of their stop losses.

Usually there are two different types of traders:

1) For example, in some cases the stop loss could be placed too close to the market. A key sign is whether you see many of your trades are being stopped, while later on the trade does actually materialize as planned. The added risk which wider stops create can be compensated by reducing the lot size.

2) In other cases you might be hitting your profit targets but realize that your reward is not sufficiently compensating your risk. In those cases you might want to consider tightening your stop loss size.

But there are other key and crucial elements to consider with regard to the best stop loss placement. Read here a great article about using tight stop losses.

1) Currency pairs vary in terms of volatility, spikes, and the average distances on a daily basis. It is recommendable to learn and get a feel for the currencies you trade regularly.

2) Your stop loss depends on the type of strategy. Stop losses can differ depending on the strategy you choose. For example, trending strategies are different than ranging strategies.

3) The time frame you use for trading. Using a shorter time frame requires traders to use smaller stop losses to enable decent reward to risk. Stops for such a scalp/day trade should be different from that of a trade taken for a swing, based on the daily, or higher timeframes.

4) Where are big Fibonacci levels, key resistance and key support levels on higher time frames? These can provide great shelter for stop losses.

5) Your trading character and trading psychology are important to factor in as well. Can your mentality handle a small stop loss? Are you really able to live with a 150 pip stop loss?

6) How does the structure of the market look like? It the currency chopping and going sideways or is there a clear pattern visible?

Stop loss levels to consider

Here are some concrete tools which you can use for your trading to actually place your stop loss. I am sure there are more examples but here are a few of them:

1) Fibonacci retracement levels

2) Tops and bottoms

3) Swing highs and swing lows

4) Candle stick highs and lows

5) Invalidation levels of the Elliott Wave Theory

6) Consolidation zone / resistance – support areas

7) Trend lines

8) Fractals

9)  Trailing stops: http://winnersedgetrading.com/trailing-stop-loss/

Must read materials

There is really tons of great value on the Winners Edge Trading website that you do not want to miss out on. So I am going to make a very easy list for you that summarize the topics connected to Stop Losses. Make sure to read through them this weekend.

Reward to risk:
* Maximize profits and minimize risk
* Minimizing risk, Maximizing reward
* Using 2:1 R:R 

Risk/money management:
* 5 reasons “standard risk” doesn’t make sense
* Trade size in Forex is important
* Forex trading plan with money management
* Stop losses risk management in Forex trading

General articles:
 * 3 easy steps to guaranteed profitable trading
* 97 top Forex mistakes 

A second part

Ok folks, that’s it for today. I hope you enjoyed it.

If you did like, then please leave a short comment down below. If there is enough interest I will write a second article about some practical examples where you can actually place stop losses using the tools mentioned above. So don’t forget to drop a note if you are interested in that.

Thanks again for your reading and have a great weekend!

Good Trading!

P.s. our twitter is @winnersedgetrad.

Here is the 2nd part of the article, click here!!!

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  • Hi Marketman, thank you, I am glad to read that you enjoyed the article. 🙂 This Friday’s article will address the actual placement of stop losses as well. Hope that will help as well. In any case glad you liked this article and thanks again. Good trading! Chris

  • Hi E.V., thank you for the feedback on the article. In general, tops and bottoms are indeed good areas to place a stop loss, although there are options a trader might want to consider when choosing the time frame. More on that in this Friday’s article. The topic seems to be very popular so I will write a part II. Thanks again and good trading! Chris

  • Hi Farah, I am very glad to read that the article is interesting and helpful. Thank you too for your comments 🙂 and wish you Good Trading this week! Today’s article will be partly on XAG 🙂 Cheers! Chris

  • Hi Pete, thank you too for the feedback and for reading the materials. Good trading! Chris

  • Thank you Eric! Good Trading! Chris

  • Thank you Harmish! Glad you enjoyed it, good trading! Chris

  • Hi Joe, thank you, I am glad that you enjoyed the article 🙂 thanks too for the feedback. Yes will indeed emphasis this in the 2nd part, which will be released on Friday the 5th of April. Thanks again and Good Trading!

  • Marketman

    Great article. Knowing is easy. Doing is harder. Thanks for the excellent information.

  • Pete

    I’ll read the 11 articles you mentioned – Thank you for providing the links.

  • Farah

    Thank you very much. That is indeed a fantastic reminder on what I must do. Thank you again and looking forward to your next article.

  • E. V.

    As a beginner, I did not make myself unconfident
    by “knowing” much yet 🙂 (I just feel it is coming), but I certainly
    finding myself comfortable using “Tops and bottoms” and “Swing highs and swing lows” in regards to determine my stops. And I would like to admit – our
    unconsciousness, probably, is stronger than conscious part when we are
    “gambling”, so, to honestly analyze our own performance as a trader
    is a first thing to do…

  • eric lambert

    Great info guys

  • hamish

    Excellent articles, thank you

  • JoeR

    Hi Chris, great article. You mentioned this, but maybe it is worth emphasising clearly – the stoploss should determine your position size. If it doesn’t then you don’t know how much money you are risking which is scary! This means every trade will be a different size. Trading a fixed size every time may cause huge losses on a single trade.
    From your entry to your initial stoploss is your risk in pips. Your position size determines the dollar value of those pips, and of your risk. Ideally for every trade the dollar loss potential is a fixed %age of your capital, say 2% or less. ie, if you have $10,000 and your initial stop is 60 pips from your entry, and If you decide to risk 2% ($200) each trade, then for this trade your position size will be 0.33 lots (which is 3.3minilots or 33 microlots or 33,000dollars). As your account grows, the 2% becomes a higher dollar value, allowing a larger trade size for the same pips risked.
    Nathan has posted an EA previously that automatically makes your position size correct for your risk when you enter a trade.