One of the most important aspects in trading is risk management, and trading without a stop loss is a recipe for disaster. You need to develop the discipline to use a stop loss if you ever want to become a successful trader. Before you even place a trade, you need to set up a stop loss to manage your risk right from the start of the trade.
A stop loss is a predetermined point at which you admit you’re are wrong on the trade, and you’ll close the trade if reached.
What is getting “Stopped Out”?
Getting stopped out is when your stop loss is triggered without your will. It is a premature closing of the trade, and is an indicator that the trader placed the Stop Loss in the wrong place, or for the wrong times. It is for this reason that you want to double check your stop loss levels, or change your stop loss should the market conditions change. Getting stopped out of a winning trade prematurely can be a frustrating experience.
That said, here are some of the most advanced stop loss techniques that every trader has at their disposal to protect an account balance.
The percentage-based stop loss is the most popular way to manage your risk. This type of stop uses a fixed amount of your account balance, usually no more than 2%, on each individual trade. The percentage stop usually depends on your risk tolerance, but many professional traders abide only by the 2% rule.
To determine the dollar amount risked per trade, you need to use the following equation:
Example: if your account balance is $10,000 and your risk tolerance is 2%, the dollar amount risked per trade is $200.
Your stop loss will be activated when the market reaches the $200 threshold. By calculating the dollar risk per trade, we can quantify how much we’re going to lose if the trade goes against us.
The volatility stop is a stop based on the historical volatility. In this case, your stop loss is directly proportional to the market volatility. If the currency pair is very volatile, the stop loss will be bigger. Inversely, if the market volatility is low, your stop loss will be much tighter.
The way Forex traders can gauge the market volatility is by using the ATR (Average True Range) indicator which calculates how much a currency typically moves.
If a currency pair normally moves 100 pips a day and it suddenly moves 200 pips you probably want to get out.
The benefit of using the volatility stop is that it adapts to the market volatility and not an arbitrary price.
Trailing Stop Loss
A trailing stop is an effective way to hold an open position for a longer period of time. A trailing stop accomplishes three things:
- Locks in profits
- Helps you ride the trend and take advantage of trending markets
- Doesn’t limit the profits while only limiting the potential losses
When you already have a trade that’s going in your favor, and if you want to have an effective exit strategy, you can use a trailing stop. A trailing stop loss order is a great way to optimize your profits.
Example: If you’re currently holding a long position that has gone in your favor you can place a trailing stop at a predetermined distance from the current price, usually below the most recent swing low or below an important support level.
The trailing stop needs to be set at a price distance that factors in the small price fluctuations so you won’t get stopped out prematurely from a winning position.
The chart stop is a widespread stop loss technique that it’s often used in combination with the percentage stop. This is a more practical way to determine where to hide your stop loss because it takes into consideration what the price is doing.
With a chart stop, you need to adapt and use significant technical levels for reference as a place where to hide your protective stop loss. The most common chart places to hide your stop loss are support and resistance, round numbers, swing high and swing low levels, indicator-based SL and chart patterns.
When using a chart-based stop you need to account for the market noise and add a buffer to your SL so you won’t get stopped out prematurely.
A time stop is a more advanced technique to manage the risk, and day traders and institutional traders often use it. The time-based stop loss uses a predetermined time to get triggered. So, instead of using the price measurement, we use the time measurement.
Basically, when using a time-based stop, if the market doesn’t move or act in a certain way during your predetermined time frame, you close the position.
The time-based stop loss is a powerful tool to use under certain market conditions. So, to make the best out of a time-based stop you’re better off to use this technique when you trade volatility expansion setups or a breakout.
Too Wide Or Too Tight
You can have the best trading strategy in the world, but if your stop is too tight, you’re going to be stopped on the slightest bit of noise. If your stop is too wide, you will not be able to take too much risk, so that’s the reason why stop losses are so important. Using the right stop loss strategy can make the difference between losing and winning.