What’s a Stop Loss Order, and How to Use It?

The pros and cons more pros of stop loss orders, and the different ways to use them.

Let’s face it. The market will always do what it wants to do and move the way it wants to move.  Every day is a new challenge, and almost anything from global politics, major economic events, to central bank rumors can turn currency prices one way or another faster than you can snap your fingers.  Without it making any sense…

Which means that every one of us will eventually take a position on the wrong side of a market move. So, why would you do it without a stop loss order?

Why play at random with no protection?  Isn’t that exactly the same risk as sleeping with a new partner without a condom?

It’s called gambling and the name of the game is…

 

Russian Roulette

Being in a losing position is inevitable, but we can control what we do when we’re caught in that situation.  You can either cut your loss quickly which will aid in taking the stress out of trading.

Or you can ride the waves in the wrong direction with your fingers crossed and your nerves jangled.  In the hope that the market will move back in your favor.

Of course, that one time it doesn’t turn your way could blow out your account and end your budding trading career in a flash. The saying, “Live to trade another day!” should be the motto of every trader not just Elite Traders because the longer you can survive, the more you can earn, and the greater your experience will be.

This makes the trade management technique of “stop losses” a crucial skill and tool in a trader’s toolbox.

Having a predetermined point of exiting a losing trade not only provides the size of your risk per trade and give you the benefit of cutting losses so that you may move on to new opportunities, but it also eliminates the anxiety caused by being in a losing trade without a plan.

Less stress is good, right?

And it changes the very nature of the game you will now be playing.  You are no longer gambling, no more playing Russian Roulette with your capital.  You are back in the realms of trading using probability and risk to make money.

roulette wheel

Stop Loss Order

Now before we get into stop loss techniques, we need to go through the first rule of setting stops.  When entering a trade your stop loss point should be the “invalidation point” of your trading idea. If the market moves to this point and beyond the trade no longer makes sense to you. That is where you put your stops.

This is part of your exit plan and is limiting the risk you are placing on each trade.

When using stop loss orders there are a few things you should know though. While using them is always highly recommended, how they are used varies from trader to trader. There are three common ways traders use stop loss orders:

  • A stop loss is used to exit all trades. The trader sets a stop loss on each trade at a price level they wish to exit a losing trade at. This is a regular stop loss and is used as the only exit plan for a losing trade.
  • A trader manually exit trades as opportunities arise and conditions change but will set a worst case stop loss order to limit losses in case a manual exit isn’t possible or doesn’t occur.
  • As a winning exit plan.

The Stop Loss Order

Whether regular, worst case, or winning exit plan serves to get you out of a position if you’re disconnected from your broker because of an internet or power outage (assuming your order made it to your broker before the outage occurred), you need to run to the bathroom but don’t want to exit your trade quite yet, or you want to have more time for other activities.

Using stop losses on a regular basis is a good idea as it forces you the trader to be disciplined in getting out of losing trades. At minimum a worst case stop loss should always be used.

Stop loss orders execute automatically, which is often a good thing during a losing trade. Humans tend to hang on to losing trades (loss aversion), so having a stop loss in place assures the trader limits all losses to a small amount of account capital. As long as you remember to a) leave it alone and b) never move it against yourself i.e. never increase the risk of the original trade… NEVER

 

How To Set A Stop Loss Order Based On A Percentage Of Your Account

Let’s start off with the most basic type of stop: the percentage-based stop loss.  The percentage-based stop uses a predetermined portion of your account.   For example,  “2% of your account” is what a to risk on a trade.  The percentage risk can vary from trader to trader. More aggressive ones risk up to 5% of their account while less aggressive ones usually have less than 1% risk per trade.  Once the percentage risk is determined, the forex trader uses his position size to compute how far he should set his stop away from his entry.

This is good right?                                                                                                                                                  Book cover "SFXA Trading Plan"

A trader is putting a stop, which is in accordance with his trading plan.

This is good trading, right?

WRONG!!!

You should always set your stop according to the market environment or your system rules, NOT by how much you want to lose.

Before you brain starts to fry let me explain. You cannot decide your lot size first and work backwards.  Let’s imagine you have a $1,000 account and you decide that you are prepared to risk 2% per trade and that your lot size will always be 0.1 standard lot, at roughly $1 per pip your stop will always be 20 pips away. Very rarely will that be a safe distance away.

When working out stops based on percentage you will need to establish your pip risk first. This could be 100 pips, 10 pips below the low of the previous wave for example. So, in this example we would divide 20 (2% of 1000) by 100 (pips). Which will then determine your lot size of 0.2 based on this example trading EURUSD.

For an easier way I would suggest using a Position Sizing Calculator that’s keeps a breast of the current usd cross ask price. The explanation of which is outside the scope of this post.

This method will keep your stops in the right place and your risk manageable.

 

Where To Place Your Stop Loss Orders

Stops should always be placed beyond levels of support or resistance. This can be horizontal levels of support/resistance, trend lines, moving averages or highs and lows.  This will then give you the greater chance to stay in the trade and bear the fruits of your labour.

For those of you who are unhappy that your stops get taken out before the market moves in your direction. Move your stops further away, check your broker spreads or pick a new line of work.

It happens… suck it up or you will spend the rest of your trading days stressed and anxious.

 

Using a Stop Loss Order as Your Winning Exit Plan

There are several ways to use a stop loss as an exit strategy.  All of which are great in the correct environment which can only be established by testing.  Here are my three favorites’:

  1. Follow on – When the market closes above/below 1:1 move SL to BE (Break Even). Then when the market closes above/below 2:1 move SL to 1:1 and so on.
  2. Manual Trailing Stop – If buying, when the market makes a new higher low move the SL a set distance below that low and reverse when selling.
  3. Automated Trailing Stop – perfect for fast moving markets. Decide how much pip profit you are willing to give back to the market and then trail the SL automatically that distance from market.

Each has its own merits and can only be verified by testing yourself with your system.

 

Don’t Be The Gambler

Always take a leaf out of our Elite Traders Trading Plan and that is always this first thing to consider when you decide to place a trade.  Where do I need to place my stop, and does it align with my equity management plan?

For more information on our Elite Trader Program please click here. Our next intake will be the 1st August and we have limited spots due to the high intensity coaching that we offer. Don’t let yourself feel disappointed, reserve your spot now.

If you’d like to have a Strategy Session with either myself

Callum@specialfxacademy.com

Or Andres

trader@specialfxacdemy.com

Please do not hesitate to get in contact

 


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Callum McLean

Co-Founder and Trading Psychologist at Special FX Academy
Trading Psychology Coach and Certified NLP Coach. It is my belief that trading is 99% Psychological. And it is by understanding and improving your psychology, that you can be a successful trader. Success is a formula that everyone can and should learn.
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