Stop Your Losses

By Mark Thomas -Trade On Track

In the last article I talked about developing time-based trading strategies and I gave you a few ideas to think about. Sometimes you just need to see or read about a different way of looking at the markets for it to trigger some inspiration, so I hope the article provided some food for thought.

Eager to take up the challenge myself, on the weekend I spent an hour or so going back through the EUR/USD charts looking for possible trade strategies based on time. I’m pleased to tell you that I found one almost immediately which looks very promising. It’s based solely on time and price action, no other indicators – so it’s very simple to learn and implement. I’m going to write a back-testing script and run it over some historical data to see how it fairs longer-term, so I’ll reveal the strategy as soon as I’m happy with the testing.

In the meantime there are several important facets of an overall trading system which I’d like to discuss. Today I’d like to talk about stop losses.

Stop losses are of critical importance in controlling your risk and exposure to the market. In order for you to stay in this game longer than the average Joe Blow, you must control how much you are willing to lose each and every time you execute a trade. Trading is never a 100% sure thing … make sure you get used to that fact. So, you must be prepared for the times when price goes against you and you must not let it go too far. Remember the phrase “cut your losses short and let your profits run”. This is a very important rule to remember and one that you can implement by using effective stop losses.

Without a firm stop loss in place, it’s all too easy to just let price go against you, further and further, hoping it will turn around and go in the right direction at some time. Even if you have fantastic statistics “proving” that price will eventually turn around and go back into profit, what if it doesn’t? This is a very quick way to wipe out your trading account – by not placing a stop loss. You must treat each individual trade seriously, but remember that your trading is not based on just one trade. Each trade is just a statistic in your overall batch of trades. You have to be prepared for a string of losses and make sure you manage the risk on those losses in order to maintain a healthy trading account balance. Capital preservation is imperative!

A couple of months back I looked through a number of trading strategies that were used in a forex trading competition. There were very detailed descriptions of the strategies including where to place the stop and where to take profits. The results were phenomenal in many cases, even with conservative lot sizes being placed on live accounts. So, I went back through the trading statements that they openly provided – probably something that not many people would actually take the time to do, because there were sometimes hundreds of trades listed on each statement. I manually worked my way through each trade on the statement and looked back at the charts to see how it actually played out. Many of the trades were as per the description of the strategy, but then – some were not! The way that the transactions were sorted cleverly hid a very important fact: that stop losses hadn’t been used or were so wide that they were not hit when they should have been. Yes, with a bit of luck you can get away with that for a couple of weeks or a month, however long the competition runs for, but sooner or later you will come undone, in a big way!

This is basically cheating – cheating in the competition and ultimately, cheating yourself. You will be the one who suffers if you play the “just wait until price comes back because it eventually will” game.

So, the message here is: always use a sensible stop loss. It’s preferable to actually place a stop loss order in your trading platform, but if you don’t – then make sure you stay glued to the screen ready to close the order if price hits your “virtual” stop loss point.

Where should you place the stop loss? Many traders recommend working out how much you can risk on the trade, then calculating a stop loss at that point. Personally, I don’t prefer that method because it’s your available funds that are dictating where your stop goes, totally neglecting the action of the market itself. I prefer to work the other way around, determining where the stop should go first, then calculating position size using that stop level.  I use technical analysis or statistics to determine how much room I will give price to move, while still in the bounds of my trading system rules. If it goes past those levels, then that’s where I will place my stop and cut my losses.  I then calculate my position size based on the stop loss point and the risk level I’m comfortable with. I’ll get into much more detail about risk management and money management in another article, so don’t worry too much if you’re lost on that bit.

Here’s an example of determining a stop loss point:

Here, I’ve entered a long trade at the position of the black dotted line (1.7922).  I’ve placed my stop loss (the red dotted line) at a logical point based on my trading strategy, which is just below the last swing low (1.7792).

From this, I know that I’m risking 130 pips on this trade (1.7922 – 1.7792).  I can then calculate the correct position size based on that figure, my preferred risk level and account balance. (More on this in a future article).

In summary, never forget to place your stops, they are an extremely important part of an overall trading plan. When I show you this time-based strategy that I’m developing, you’ll see just what a difference correct stop loss positioning and money management can make.

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