Stop Loss: A Minefield for Most Forex Traders

by: The LFB

Stop Losses really can be an Achilles heel in trading, especially day trading the leveraged moved made in the forex arena, and every Trader wants to always find the ideal place to put them. There is no direct, coverall answer to where, and in reality the correct stop may require just as much work as the exact target placement. It is a shame but there really is no easy fix to this, and relies as much on the time that the trade is placed as well as the likely market momentum at that time.

Market conditions dictate the depth that a stop needs to placed away from an entry point. In current conditions, with a lot of volatility, some stops may need to be at a 1:1 Risk to Rewards (in other words to be risking 30 pips in an effort to gain 30 pips). As markets start to trend, that may go to risking 30 pips to gain 60 pips, and the Risk:Reward increases to 1:2. Over the course of a traded year the average Risk/Reward will likely be between 1:1.5 to 1:2, with times of constant 1:1, and others with runs of 1:3.

To go with a 1:1 Risk/Reward a trader obviously needs to have more than 50% winning trades to get above break-even. With a 1:2 Risk/Reward a Trader can be right 50% of the time and still be very profitable. Therefore market conditions are incredibly important, as is the need to work on money management. A stop area needs to be found first, and then the amount of lots traded worked from that pip count.

For example, if a trader commits no more than 2% of their $10k account balance on any one trade, they have a risk exposure of $200. If the Stop area is 20 pips away they can trade 10 mini lots ($200 divided by 20 pips). A stop that needs to be 50 pips away, because of market mechanics equates to 4 mini lots ($200 divided by 50 pips). Downloadable Excel Stop/Risk Calculator

In current conditions, with the need to have bigger stops because of the thin volume and a tendency to whipsaw before committing, it is important to start with the target area. Ask yourself how realistic is the amount that you are aiming for? Your entry must be breaking some kind of previous support or resistance to generate momentum to get you as quickly to the target as possible. If it is realistic, and for example 50 Pips away from the entry, then you may need to allow up to 50 pips as a stop in the current conditions, and that may mean a smaller position size. Take stock of the weekly moves that this pair makes, and compare that to the daily trading range (deduct the high from the low). Understand that if a pair moves 80 pips each day on average, that to set a target that tries to capture all of that may be very difficult in one go. Either look to reduce the target, accept that reaching that target may take a little while longer than expected, or set targets that close out part of the order in stages.

Trying to get in the habit of not just parking the Stop 50 pips away, and then moving on to another trade will increase profitability over time. Do the same with the stop as you did with the target, spend time on where it needs to go, look for an area that has shown to be good support recently, dig and delve and look for areas that gave reversal signals, on this pair and other pairs that may have shown it at the same time. Spending time on stop placement, and increasing the attention given to it, is going to be a critical stage of going from a part-time to a full-time trader.

A major thing to add to your trade plan, and to really begin to consider seriously is the time of day that you are in the market. If it is in high liquidity times, 1am - 10am EDT, the stop may not need to be as flexible or as large as it will if a trade is initiated after these hours. Working the momentum of the London Open, and then the US follow through can impact the way a stop loss needs to be analyzed. High Liquidity = High Movement, and that in turn equates to quicker moves to the target area.

Whenever the volume spikes above the 10 period Moving Average line running through the volume study is when the targets are going to be more easily hit, and that equates to getting the most momentum through the London open to the New York open, 02:00-10:00 EDT. Most stops will be hit outside of those times.

Disclosure: No Positions