There are many questions regarding how to
place stop loss orders and which technique
to follow.
Although there isn’t a single approach that
is better than the other, knowing your options
and how to place a stop loss with different
techniques is very important.
So today we’ll go through the most commonly
used methods for setting stop orders.
Essentially, a stop loss is a pre-determined
price at which you exit a position in order
to limit your loss (or protect your profit).
A stop loss is all about the exit strategy
in your trading plan.
Choosing which type of stop loss to use depends
on the goal of your trading strategy.
For example, for a swing trading strategy
it makes sense to use a wide stop loss to
allow the price to rally and retreat as the
trend rises.
If you are a short term trader, a smaller
stop loss will hug the price activity and
help you not to give back too much profit
when the rally finally ends.
No matter what type of trader or investor
you are, my advice is to always use a stop
loss order.
Every successful trader knows where they will
get out if a trade goes against them.
They plan every trade before getting into
it.
Some traders are scared that if they place
a stop loss, the broker will try to cheat
them by moving the price to the stop loss
level causing a loss.
This does happen, but it’s no conspiracy.
Getting stopped out is just part of trading
and the stop loss itself isn't the problem.
The point is that every trader will take losses
and have their stop losses hit...a lot.
Therefore, using a stop loss isn't really
a question.
As a trader, you need to control your risk
and losses, especially when using the kind
of leverage that is available to Forex traders,
for example.
So let’s discuss the alternatives in terms
of stop loss placements.
1.
First one: Moving averages
Moving averages are a popular tool and they
can also be used to place and manage stop
loss orders.
Usually, a trader will use a moving average
and then place the stop loss on the opposite
side to current price.
In the example as we take a long trade, we
could move the stop loss below the 20 MA as
the trend unfolded.
The moving average is, thus, also potentially
ideal when it comes to finding a trailing
stop method.
A potential trade exit happens once price
breaks the moving average.
The big question about such a stop loss strategy
is which type of moving average to use.
A fast moving average will get you in and
out of trades relatively quickly because it
reacts faster to price changes.
A longer moving average is usually better
suited for swing trading where you aim to
ride trends longer.
And of course, during range markets, the moving
average doesn’t provide much help because
price does fluctuate a lot around the moving
averages.
2.
Next type: Previous swing points
This is probably the second most popular way
of placing and managing stop loss orders.
Here, you identify natural swing points on
your chart and place your stop loss below
or above those points of interest.
The trade exit happens once price breaks such
a swing point.
Also, many traders use intra-day highs and
lows, or previous days’ highs and lows to
set their stop loss orders using this method.
If you are a breakout or a range trader, this
way of placing stop loss orders has to be
adjusted slightly and you should look for
support and resistance areas to place your
stops.
3.
Another alternative is Fibonacci levels.
Using the Fibonacci stop loss approach is
especially interesting because it offers a
more objective way of placing stops.
Whereas you have to make decisions subjectively
when to move a stop based on the moving average
or swing strategy, Fibonacci levels don’t
have this component.
Once a trader has drawn his Fibonacci levels,
its potential stop loss levels are well defined.
In this example, we drew the Fibonacci tool
during the downtrend and then used the retracement
levels to trail the stop loss.
The trade exit happened once price failed
to move to the next retracement level.
4.
Pivot points are another great way to set
stop losses.
Pivot point are even more objective than Fibonacci
levels, because they are not set by the trader
but adjust every day based on price action.
The way pivot points are used is the same
as with Fibonacci; whenever price breaks a
pivot level, the stop loss is trailed below
that level.
Pivot points are my favorite way of setting
stops and managing trades because they adjust
based on price action, market volatility and
momentum.
During a stronger trending market, pivot points
are set further away and during a low volatility
market, they are closer together.
5.
We also have volatility stop losses
Traders often set their stops too close when
volatility is high, or they set stops too
far away when volatility is low and, thus,
reduce their potential reward-risk ratio.
A volatility stop, just like pivot points,
adjusts based on the market context.
Furthermore, a volatility stop loss can be
combined with the previously discusses stop
loss techniques.
For example, if you use moving averages to
place stops, you could add the volatility
stop loss to understand how close, or how
far, you have to set your stop loss to the
moving average based on current volatility
and market context.
There are several indicators you can use to
take advantage of volatility stop losses and
CHANDELIER EXIT is one of those indicators.
Chandelier Exit is based on the Average True
Range (ATR) indicator and is designed to keep
traders in the trend until a defined trend
reversal happens.
Also, Bollinger Bands are rarely mentioned
as a stop-loss tool.
But its usage of standard deviation makes
it a natural candidate.
For instance, the lower Band works well as
a stop-loss for a long position and the upper
band for a short position.
As the Bollinger Band is not designed as a
stop-loss tool, it widens when volatility
is high.
Hence, when you use it as a stop-loss tool,
remember to ignore the parts where the Band
moves away from price.
Adjust the stop-loss only in the direction
of the trade.
And finally, Parabolic SAR is another indicator
that incorporates both price and time to place
stop-losses.
Now let me cover the most common errors regarding
stop placement to avoid, if you want to take
the best trading decisions.
First error is not determining your stop placement
in advance.
You should know where your stop is going to
be before you open a trade.
The same goes for your entry and target(s).
The benefit of ascertaining your stop before
you open a trade is that it removes any emotions
from the decision, because you haven’t yet
risked any of your capital.
Second error: placing your stop based on arbitrary
numbers.
The market doesn’t care about your Risk:Reward,
some magic number 2% away from your entry,
or some other figure.
One of the biggest errors you can commit is
to try to make the market fit your framework
as opposed to fit your framework to the market.
While it’d be very convenient if there were
some magic number or equation you could apply
to get a bulletproof stop placement, no such
thing exists (to my knowledge).
Therefore, when it comes to deciding where
to place your stop loss, that decision should
be based on technical analysis.
Stop placement should not be based on some
magic price level which meets a certain percentage
or gives you your desired R:R. The market
doesn’t care for that.
Another major stop loss mistake is moving
your stop to break even as soon as possible.
The goal of a stop is to protect you if your
trade idea doesn’t work out and is not to
offer you a “risk-free” trade the moment
it moves in your favor.
Most people would agree that the stop should
be based on technicals, yet happily move their
stop to break even if the price moves in their
favor.
This is contradictory.
Moving your stop to break even is similar
to calculating your stop placement based on
arbitrary numbers (the error we discussed
before).
The market doesn’t care where you entered
and where you’re break even.
The moment you arbitrarily move your stop
to be “safe” you also abandon a technical-based
approach to the position (unless, of course,
your break even happens to coincide with a
technically significant level).
Another mistake is never moving your stop
As mentioned, the goal of a stop is to protect
your account if your trade idea is incorrect.
However, once the market proves to you that
your trade idea may be accurate as it moves
in the expected direction, your stop can be
used protectively to maintain a good R:R as
price heads towards your target.
If you blindly move your stop to breakeven
as soon as you can, that’s an arbitrary
decision which isn’t based on technicals,
it’s just an emotional decision to feel
“safe”.
But if you move your stop as the market proves
that it’s moving in the expected direction,
that’s a decision based on technicals and
a good way to maintain a good R:R as price
heads towards your target.
The right value for a stop loss comes down
to your trading time frame, your back tested
strategy results and what you feel comfortable
with.
There is no right or wrong and no single approach
is better than the other.
But, it’s important that you understand
the pros and cons of each approach and learn
how to combine different aspects to form a
trading method based on your preferences and
personal trading mindset.
As always, if you learned something new and
found value, leave us a like to show your
support, subscribe to our channel and hit
the bell icon to stay notified when we upload
new videos.
Until next time.
