How Stop Losses Could Save You From Yourself15th June 2019
Talking about stop losses is one of those less popular subjects. No one likes to dwell on trades that are going south!
But, statistically speaking, around 40% of the trades that successful traders make are not going to work out. Even among unsuccessful forex traders, usually, their issue is that their losing trades are bigger than their gaining trades.
The trick to successful trading is minimizing drawdowns. And, in many cases, the distinction between success and failure is money management, in which stop losses play a pivotal role. Beyond simply providing the safety that a trade won’t run away on you while you’re not looking, having loss management as an integral part of your trading strategy might be precisely how you get the most out of the markets.
It’s Not Just the Size That Matters
Many beginner traders start with a single fixed rule for their stop losses. A good one is to set a maximum loss on your trades that is a percentage of your account.
For example, studies have shown that forex traders who risk more than 3% of their account on any given trade are not any more successful than those who risk less than amount. So, calculating how many pips is equal to 2% of your account and always setting a stop loss at that level will help minimize the loss of your bad trades.
Another similar and even simpler option is to have a fixed number of pips for your stop loss. Say, every time you open a trade, you set the level at 100 pips from market entry. This one is ideal for people who tend to have a problem with “closure discipline”. That’s when your trade is obviously moving in the wrong direction, but you can’t bring yourself to close it in the hope (not calculation or strategy) that the market will turn around.
The Market is Always King
While both of these techniques are definitely better than losing even more, they don’t take into account the current trading conditions of the market. Or even your trading style. If you are taking short term trades, banking on getting a small number of pips with a larger number of trades, then having a very wide stop loss will lead you to losing an unnecessary amount of pips.
Likewise, market volatility is not constant. If you are trading during hours when the market moves less, having a too wide a stop will mean that it won’t be triggered in time to save you money. Or if the market has increased volatility, it will stop out too soon.
There is nothing more frustrating in trading than to get stopped out, and then watch the market turn to your favor. You can use the Average True Range indicator on your platform to help gauge how much the market is actually moving.
The Sooner the Better
One of the ways to make your account more profitable is to narrow your stop losses when you perceive the risk of the market going the wrong way is increasing. This might sound counterintuitive since the stop loss is sort of the “breathing room” for your trade. But the general principle of trading is to manage risk, and a shorter stop loss implies less risk.
Unless you have years of experience, you should never move your stop loss further away! This is the psychological trap that can lead to significant losses.
Practice Makes Perfect
If there is a particular risk situation coming up, you can move your stop loss closer. For example, if your trade is running through a data release that could move the market significantly in one direction, you can move your stop loss closer to the market to minimize the size of your loss if the data isn’t good for your trade.
As you gain experience trading, you’ll be able to refine your strategy. Getting better at knowing when to enter the market should go hand in hand with getting better at finding the right range for your stop losses.
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