The Art of Setting a Stop LossAs a trader, the most crucial responsibility you have is to manage and preserve your trading capital. You're out of the game if you lose all of your trading money; there's no way to make up the difference. If you make pips, you must be allowed to retain them instead of returning them to the market. But, let's be honest, it's not going to happen. The market will always do what it wants and go in the direction it wants. Every day brings a new set of challenges, and practically anything from geopolitics to unexpected economic data releases to speculations about central bank policy may swing currency markets one way or the other quicker than you can clap your fingers. This is exactly why you need to use appropriate stop losses in your trades. Generally speaking, there are 4 main SL types you can encounter on the market: volatility stop, chart stop, percentage stop and time stop.
Let's begin with the most fundamental sort of stop loss: the percentage-based stop loss. The percentage-based stop employs a portion of the trader's money that is predefined. For instance, a trader's willingness to risk "3% of the account" on a deal. The percentage risk varies depending on the trader. More active traders risk up to 5-6% of their account, while less aggressive traders often risk around 1% every trade (that’s what we do as well).
Important rule of thumb here is: Always set your stop loss based on the market or your system's criteria, not on how much money you want to lose. This means that observe and learn each pair you trade. 20 pips SL on EURUSD, might be not enough on a GBPJPY trade. Some pairs make 120 pips move a day, while others average at 60. Oh, and don’t you forget about the pip value difference.
Based on what the charts are suggesting is a more rational technique to identify stops. One thing we can notice in price movement is that there are times when prices don't seem to be able to push or break through particular levels. When these levels of support or resistance are retested, they can sometimes prevent the market from moving upward again. Setting stops above and beyond these levels of support and resistance makes sense since if the market trades beyond these levels, it's logical to assume that a break of that region will attract more traders to play the break, pushing your position further against you.
Important rule of thumb here is: Set your stop losses couple pips over under the major key points, so you don’t get affected by the market noise.
More uncommon way of setting a stop loss is based on volatility (which is already considered in percentage stop loss). Volatility, to put it simply, is the amount a market might potentially fluctuate in a given length of time. Knowing how much a currency pair tends to change might help you establish the right stop loss levels and prevent getting pulled out of a trade prematurely due to market swings.
Important rule of thumb here is: Study your ways to determine daily volatilities as they do change. Two common ways of doing so is through Average True Range (ATR) and Bollinger Bands.
Stops established based on a preset time in a transaction are known as time stops. It might be a specified time (open limit time of hours, days, weeks, etc.), only trading during specific trading sessions, the market's open or active hours, or something else entirely. Set a deadline and get rid of the dead weight so money can accomplish what it's supposed to.
Important rule of thumb here is: The time stops ultimately come down to what type of trader you are. So before, you start setting time limits you should understand whether you’re intraday, swing, long-term trader.
Conclusion: We often draw a line between good traders and “The BEST”. What makes a difference in this case? Good trader uses a certain type of stop loss. “THE BEST” traders use a combination of all. An example would be looking at a EURUSD pair. We do our technicals, we have a predetermined percentage in our mind, we have a predetermined time in our mind, and we’ve considered the volatility of the mentioned pair. For instance, we set our Stop Losses close to key zones determined by price action, we wouldn’t risk more than 1% on a single trade, we’re swing traders, so we wouldn’t keep the trade over the weekend and lastly we’ve traded enough to know the average volatilities for each pair.
Hope you found time to read this all as this will have a tremendous impact on your trading journey. All the best in 2022, family!
