Using Stop Losses and Where to Place Them

Cory Mitchell, CMT

A stop loss gets us out of a trade at a predetermined price or loss amount.

A stop loss can be mental or physically placed. An example of a mental stop loss is a trader buying the EURUSD at 1.1250 and saying they will get out if the price drops to 1.1225. They are risking 25 pips, but when the price reaches 1.1225 they will need to manually get out.

Mental stop losses are typically used by day traders who can watch their screens in case the stop loss price is reached, or by long-term traders who can monitor their charts every once in a while and still have time to see when the price is creeping up on their stop loss level.

An example of a physical stop loss is when a trader places an actual offsetting order at the stop loss price. For example, if a trader shorted the AUDUSD at 0.7530 and placed a stop loss at 0.76, the trader is risking 70 pips. If the price touches 0.76 the stop loss will be executed, buying the AUDUSD to close out the short position.

To Use or Not Use a Stop Loss

Every successful trader knows where they will get out if a trade goes against them. They plan every trade before getting into it.

Therefore, using a stop loss isn't really a question. As traders, we need to control our risk and losses, especially when using the kind of leverage that is available to forex traders.

We need to use stop losses, the only question is whether it will be mental or physical. 

If you can't be watching your screen when your stop loss could potentially be hit, then you should place a physical order. Even if you can watch your screen all day, physically placing stop loss orders is recommended. 

Some traders are scared that if they place a stop loss with a broker the broker will screw them by moving the price to the stop loss level causing a loss. This does happen, but it is no conspiracy. Had your order not been there, the price would have done the same thing. Getting stopped out is just part of trading. It happens to the best traders often 50% or more of the time...and yet the good traders still make a killing even with placing stop losses and having them get hit often.

In fact, I don't know of a single consistently profitable trader who doesn't manage their risk and losses, keeping them on a very tight leash. 

If you are getting stopped out too much, your strategy needs work, that is all. The stop loss itself isn't the problem. Some strategies win 20% of the time, others win 73% of the time, and others 55%. All can be profitable. The point is that every trader will take losses/have their stop loss hit...a lot.

Market or Limit Order Stop Loss

In the forex market, most retail brokers only offer market order stop losses. That means when the stop loss price is reached, an order is sent to get you out at the best available price at that time.

A market order assures you get out, but sometimes the exit price won't be exactly the same as the stop loss price you set because markets can move very quickly or gap (no trading occurs between one price and another). This is called slippage. It is common, should be expected in small amounts quite often, and is a cost of trading. A solid trading strategy should factor in slippage and still be profitable. 

While stop loss limit orders are less common in the forex retail setting, a limit order means the stop loss will only fill if the price available at the time of the order is within a specific band. For example, if you buy the EURUSD at 1.1175 and place a stop loss limit order with a trigger at 1.1150 and a limit of 1.1145, that means that once the price hits 1.1150 a sell order is sent out. It only fills between 1.1150 and 1.1145, whereas a stop loss market fills at ANY next-available price. 

The limit order controls the exit price with more precision but also means the trade isn't exited if the price band specified is unavailable. Assume that a news event occurs when the price is trading at 1.1160. The moment after the news event the next bid price is 1.1130. A market order will sell at 1.1130. A limit order will keep you in the trade because the price isn't between the 1.1150 and 1.1145 sell points. If the price keeps dropping the position's loss increases. The market order incurred slippage (a 20 pip additional and unexpected loss), but at least the position is closed and not facing larger and larger potential losses.

Where to Place a Stop Loss

 Simply put, a stop loss should be placed where a strategy dictates. 

Every forex trade EVER taken should be based on a well thought out and tested strategy. 

My guess though, if you are reading this, if that you working on building a strategy. Therefore, I will provide a few ideas on where to place a stop loss. Keep in mind though that where the stop loss is placed goes hand in hand with your entry technique. Therefore, I will also provide a couple of entry ideas as well. This will hopefully get you on your way to generating your own strategies.

Trend Trading Stop Loss Example

I am a big fan of trading trends. I like to watch for trends where the price has pulled back and then consolidated. A consolidation is where the price moves sideways for at least a couple of price bars. I then like to enter a trade IF the price breaks out of the consolidation in the overall trending direction.

A stop loss can then be placed slightly below the consolidation low. Since the price has already started to move higher out of the consolidation, we aren't expecting the price to drop back below the consolidation. If it does, we want to get out since our premise for the trade has been invalidated.

The following EURUSD daily chart shows an example of this.

Average True Range Stop Loss Example

Another method you can use is to place a stop loss at some multiple of volatility. A common volatility measurement tool is Average True Range (ATR). It's an indicator available on most charting platforms. 

Use the ATR reading for the time frame you are trading. For example, if you are day trading the USDJPY on a 5-minute chart and the ATR is 0.08, that means the price is moving about 8 pips (from high to low) every 5-minutes. 

If you are swing trading the EURUSD and the reading is 0.0045 that means the price is moving about 45 pips per day on average. 

Let's say you are taking a short position in the EURUSD at 1.1525. You could place a stop loss 45 pips above, which is 1xATR. Alternatively, you could place a stop loss at 1.5xATR which is 67.5 pips. Or you could give the trade more room by using 2xATR resulting in a 90 pips stop loss. 

What multiple of ATR you use will vary depending on how long you want to be in the trade and your expected profit potential. For example, if you use a 2xATR, your expected profit should be greater than 2xATR. 

The ATR stop loss method is nice because it adjusts to volatility, as ATR gets bigger when the price is moving lots and gets smaller when the price isn't moving much. Once you place an ATR stop loss stick with it. Don't expand it if volatility expands. 

For example, if you go long the GBPUSD at 1.3025 and you opt for a 1xATR stop loss (assume ATR is 100 pips). Then the stop loss goes at 1.2925, 100 pips below the entry. It stays there, or only moves up, never down. If a few days later the ATR is 110 pips, the stop loss is not dropped to 1.2915 (exposing the trader to an additional 10 pips of risk). Instead, the stop loss is always based on the ATR at the time of the trade. 

The ATR multiple method can also be used as a trailing stop loss. As the price moves in your favor, the stop loss trails it by the ATR and multiple at the time of the trade. In the example above, the stop loss is continually moved higher as the price moves higher, trailing the highest point in price by 100 pips. If the price reaches 1.3200, for example, the stop loss would be moved up  1.31. This locks in profit (75 pips so far) as the price moves favorably, but gets the trader out if the price starts moving too much against them. 

Final Word on Stop Losses

There are many different tactics for implementing stop losses. The point is to use them. They help control risk, but they can't control it entirely. Even if a stop loss is placed there is no guarantee that we will be able to get out at the price we specify. 

Getting a different price than expected is called slippage. Small amounts of slippage are common, but big slippage can occur around major news events or in illiquid market conditions. This can be mostly avoided by closing out positions prior to major news events when the price is close to the stop loss. While slippage isn't fun when it does occur, it is part of trading. It is better than not using stop losses and facing mounting losses on every trade.

By Cory Mitchell, CMT. Join me on Twitter @corymitc.

Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.

Comments

Forex Trading Tips

FEATURED
COMMUNITY