Forex traders face tough choices on trade management and exit points – although not all traders are really aware of them. Simply put, traders dislike thinking about risk and enjoy entering a setup, which is mostly because they imagine a perfect and quick profitable trade. The reality is often strikingly different.
As the experience grows traders think and plan 1 or 2 steps ahead. They start to think beyond whether the entry might look good or not and focus on what will happen after the trade is entered. They also contemplate the stop loss and take profit levels before the trade is entered.
Today’s article focuses on the stop loss placement which is a complicated topic for most traders. It is a tricky choice because it indicates where traders choose to exit a trade at a loss (unless used as a trail stop loss in some cases). Here’s a review.
POINT 1: NOT WILLING TO LOSE
In Forex trading accepting a loss is an integral part of becoming consistently profitable in the long run. No trader can ever have a perfect track record without any loss. The unwillingness to accept losses will only create problems such as moving the stop loss further from price (increasing the risk) or not even using a stop loss. Ultimately traders run a high risk of losing their entire trading capital.
POINT 2: HEAVY FOCUS ON SMALL LOSSES
Other traders are the exact opposite of the previous group (point 1). Whereas some traders have issues with accepting a loss, other traders are placing stop loss extremely close to price. They often do this to minimize the losses they endure. Problem is that the chance of the stop loss being taken out is ultra high. Usually minimizing losses is desired, but not when the stop loss is almost guaranteed to get hit.
POINT 3: USING A FIXED # OF PIPS AT ANY AND ALL TIMES
Although some traders succeed with using a fixed number of pips for their stop losses, most will fail because they don’t have enough experience with the technique and pair. Also, the market makes different size of trends and ranges. Using a fixed number of pips could at times work great when there are small price movements but fail miserably when price is making bigger movements.
POINT 4: USING A TECHNICAL STOP
Using a technical stop avoids the problem of point 3 as it is placed beyond a support or resistance level. Therefore a trader takes the current market structure into consideration when making the stop loss choice. But there are many support and resistance levels available and often traders choose the closest one. To nobody’s surprise the trade is often taken out. Famous trader Bill Williams solved this problem by emphasizing the importance of placing the stop loss beyond 2 levels of support and resistance, which indeed puts the exit further away from any spikes or consolidations that could take out the order.
In conclusion, Forex traders either like to risk too much (widening their stop loss or not using one) or risk too little (using too tight of a stop loss). Both are far from ideal.
Forex traders choose to place their exits at spots where:
- There is a high certainty of the stop loss getting hit;
- But a low chance of the target being hit.
Forex traders should be looking for the exact opposite!
We want to see our stop loss being hit less frequently and our take profit more regularly!
So how do we do that?
Winners Edge Trading has completed a ton of intensive testing on stop losses. The test results show this:
- Placing a stop loss further away from harm’s way decreases the chances of being stopped out;
- Placing the target closer to entry point increases the chances of the trade exiting at a profit before being stopped out.
The reason is simple: at any point in time price has a typical range it can move up and down – regardless of the trend or anything else. If the stop loss is relatively close to the entry level, then the chances are high that price will hang around long enough for the stop loss to be hit (at point or another). Basically, the market likes to make spikes, consolidate and float around and a tight stop loss is in serious danger of being hit when too close.
By placing the stop loss OUTSIDE of the expected range, traders can keep the stop loss at a safer distance. Don’t get me wrong, any trade setup can end up as a loss. BUT this setup will NOT get stopped out prematurely. Random price movements will not be able to endanger the trade; only a well developed momentum against our position could do that.
With the stop loss not in a position of being taken out at any moment, the trade in fact has a serious change of hitting the target.
The key to the above solution are these words: “expected range”. Winners Edge Trading used the Average True Range (ATR) in its testing and found that:
- The chances of a stop loss being hit dramatically decreased if we use 7 to 12 multiples of the ATR;
- The chances of a take profit being hit significantly increased if we use 4 to 8 multiples of the ATR.
Our high win percentage easily compensates the fact that most trades are averaging less profit than the loss. The trader of course can optimize the results by using other tools and indicators to identify the best spots within that range.
To sum it up:
By using the ATR to keep the stop loss outside of the expected range and the take profit inside the expected range, a trader can drastically improve their trading!
Now it’s your turn: do you think that this rule can help improve your trading? Let us know down below!
Thanks for sharing and Happy Hunting!
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