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What is Stop Loss? 4 Types of Stop Losses, Rules and Mistakes on Stop Loss

What is Stop Loss? 4 Types of Stop Losses, Rules and Mistakes on Stop Loss

What is Stop Loss? 4 Types of Stop Losses, Rules and Mistakes on Stop LossBefore we jump into discussing the types, you should know that the market functions how it wants and it is by NO MEANS dependent on the traders. Due to the massive changes in the global politics, economy and policies of the banks have a major impact on the currency prices. The prices can fluctuate more quickly than you expect. What that means is that with each move, we become more vulnerable to secure the wrong positions in the market.

Being in a winning position every time is not possible, no matter how experienced you are. You can easily get into the losing position. However, you also have the opportunity to cut your losses quickly when the market starts moving in your favor.

Obviously, that one time it doesn’t turn your direction could change your record towards winning and end your growing trading vocation instantly. The truism, “Live to exchange one more day!” ought to be the saying of each dealer on Newbie Island in light of the fact that the more you can endure, the more you can learn, gain involvement, and increment your odds of accomplishment. This makes the exchange the board strategy of “stop misfortunes” an essential aptitude and instrument in a dealer’s tool kit.

Having a foreordained purpose of leaving a losing exchange not just gives the advantage of cutting misfortunes so you may proceed onward to new chances, however, it likewise takes out the nervousness brought about by being in a losing exchange without an arrangement.

Less pressure is great, isn’t that So?

Obviously, it is, so how about we proceed onward to various approaches to cut them misfortunes brisk!

At this point, before we get into stop misfortune procedures, we need to experience the main standard of setting stops. This is the most crucial parts of your career and it is better to learn about it in the very beginning.

Your point of stop loss ought to be the “negation point” of your approach of trading. In the upcoming lessons, we shall learn about the 4 ways of setting stops. These methods include:

  • Percentage stop
  • Volatility stop
  • Chart stop
  • Time stop

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

The percentage-based stop loss is the most basic and most common type use in the forex market. It is designed to use a predetermined portion of your trader’s account to know when to close a position, when forex trading. In an example, let’s say that you are only willing to risk 2% of the account on a trade.

We are using 2% as an example because some traders are more aggressive and can risk up to 10% of their account and some might want to risk only 1%.

Once you know the risk percentage, you will then have to use your position size to calculate how far you should set the stop from the entry. Keep an eye on the forex signals to make sure that you do not get surprised.

Do you like the idea?

Simply put, a trader is putting a stop that is in accordance with the trading plan.

What if someone told you that this is WRONG?

REMEMBER: YOU SHOULD NEVER SET YOUR STOP ACCORDING TO HOW MUCH YOU WANT TO LOSE BUT BY HOW THE MARKET ENVIRONEMT IS LIKE AND THE SYSTEM RULES.

Yeah, we remember saying you need to manage risk by doing things like watching the forex signals closely. We know that this might sound a bit confusing but, we can explain.

Example:

This guy (let’s call him Noob Noob), has a mini-account with $500 and the minimum size he can trade is about 10,000 units. He picks the GBP/USD pair because he saw that the resistance at 1.5620, is holding. According to risk management rules, Noob Noob will risk no more than 2% of the account per trade.

Each pip is worth $1 and 2% of the account is $10 when he has 10k units of GBP/USD.

The largest stop Noob Noob can apply here is 10 pips. He does that by putting the stop at 1.5630. In real life, the GBP/USD moves about 100 pips in a day. That means he gets stopped at the tiniest movement.

Because he is setting the stop based on how much he is willing to lose instead of the market position, let’s look at what happens next.

The forex signals indicate that the market moved in his favor but, he got stopped and missed out on a chance to grab over 100 pips. Even when he was watching the forex signals to capitalize, he might not be able to do this because the position was closed too close to the entry.

From this example, you can tell that the danger of using percentage stops lies in forcing the trader to set a stop at an arbitrary price level. That means you will get stopped too close to the entry like Noob Noob, or at a level that does not include the technical analysis of what is happening in the market. How mad at your self would you be if you set the stop right at the part where the market takes a turn and heads your way?

So, What Do You Do?

If this is how things play out, Noob Noob should trade with the best forex broker and watch the forex signals closely. This will allow him to trade micro and custom lots. When he has 1k of GBP/USD, each of the pips is worth $0.10.

If he wants to stay in the comfort level of risk, he can set the top on his currency pair to 100 pips before losing 2% of the account. Mathematically:

100 pips x $0.10 = $10

Now, he can set the stop to the market environment, support and resistance and trading system, among other things.

How To Set A Stop Loss Based On Support And Resistance From Charts

After discussing how you can set stop loss using percentages, we now get into the ways that you can do it using what the forex signals and charts tell you. It makes sense that when we are trading the forex markets, we should base the stops we have on what the markets are trying to tell us.

One of the things that we can see on charts is price action and at times, the price cannot seem to break beyond some levels. Other times, when these support and resistance areas are retested, they might have the potential to hold the forex market from breaking through.

Setting stops that are beyond these levels of support and resistance is a sensible idea because, if the market does not tread beyond these areas, it stands to reason that a break of that area will attract more traders who will want to play the break and push the position you take against you.

If these levels break, it means that there are forces beyond your ken that are pushing the market.

How Do You Do It?

So, let us find out the ways in which you can set the tops based on support and resistance:

If you look at a chart and see that the pair is trading above the falling trend line, you will probably see it as a good breakout trade setup and decide to go long.

However, before you enter this trade, there are a few questions your forex education will demand of you to think about:

  1. Where do you set the stop?
  2. What are the indicators that tell you when the original idea is no longer valid?

It makes sense that you will set the stops below the trend lines and support areas. If the forex market does move into these areas, it means that the trend lines did were not supported by the buyers and the sellers are now in control.

That means the trade idea you had was invalidated and you should accept the loss as you exit the trade.

An Example: Short EUR/USD

Let’s say you look at a chart and you see that the EUR/USD has been trending down. The price has hit the falling trendlines a few times which shows a clear resistance level.

You will be better off placing a short order right at the downtrend line (1.3690)

So, where does the stop loss get set?

At 1.3800.

If you look closely, you will see that it is above the resistance area or falling trendline.

Say we set the profit targets at 1.3530 and 1.3450.

The trade is set in motion, while the trendline holds as price and resistance falls. You have managed to hit the profit target. The second profit target, you did not hit. You missed it by a single pip. However, by that time, you have moved the stop loss to breakeven (that is where you entered the short) and that means you did not lose anything.

This is just one example of how you can use resistance as a guide that points where you place the stop instead of using some static/fixed number.

How To Set A Stop Loss Based On Price Volatility

In simple words, volatility is the amount a market can move in a given period of time.

Having sufficient knowledge of the potential movements of a currency pair helps you set correct stop loss levels and keeps you in a trade on random fluctuations of price.

Let’s suppose you are in a swing trade and you know that EUR/USD has moved around 100 pips a day over the past month. You can get stopped out early on a small intraday move against you by setting your stop to 20 pips.

This is where the benefit of knowing the average volatility comes to the rescue and gives you enough room to stay in the market for long.

Procedure 1: Bollinger Bands

One simple way of measuring volatility is by using the Bollinger Bands.

Bollinger Bands give you the idea of how volatile the market is in a given period of time. If you are doing range trading, it can be very beneficial for you. All you need to do is set your stops beyond the bands.

If price hits this point, it suggests volatility is growing and a breakout could be on the cards.

Procedure 2: Average True Range (ATR)

Another way of finding the average volatility is the Average True Range method.

It is a very common indicator that is available on most trading and charting platforms.

In order to use ATR, you have to input the number of bars, candlesticks, or time to calculate the average range.

Let’s suppose you are looking at the daily chart and you input 10 into the settings. After that, the ATR indicator will calculate the average range for the period over the past 10 days automatically.

Similarly, if you are looking at the hourly chart, input in the settings will give you data on an hourly basis.

This process can be used standalone or with other stop loss techniques as well.

How To Set A Stop Loss Based On A Time Limit

Time stops are defined as the stops that are based on a predetermined time during a trade. The time limit can be based on hours, days, weeks, etc. and only during the trading sessions.
Let’s suppose you are an intraday trader and you have put a trade on EUR/CHF. There’s no point of keeping your money locked during the trade that can also be used to take advantage of more movement.

More movement is equal to more pips. Because of the rules determined before and your nature of not holding the trades overnight, let’s assume you have decided to close the position at 4 pm,
In case you are a swing trader, you may decide to close your positions on Friday to avoid gaps and weekend event risk. You should know that keeping the margin tied to a dead trade could be stopping you from getting another great trade setup somewhere else.

Always set a time limit to make sure you make more money from your money and not get stuck in the same timeframe forever.

4 Big Mistakes Traders Make When Setting Stops

4 Big Mistakes Traders Make When Setting StopsLet’s discuss the four biggest mistakes most traders make when using stop losses. We have greatly discussed and emphasized on using proper risk management, but what you need to understand is that if used incorrectly, it may lead to more losses than profits. And, certainly, you would not want that.

Placing Tight Stops

The most common mistake is placing tight stops that take away your room to breathing. Always place stops with enough room for the price to flow your way.

The ideal thing to do is to remember the pair’s volatility and the fact that it could fluctuate at the point of entry before moving in a particular direction.

Using Position as a Basis for Stops

It is always a bad idea to use position size like “$X or X number of pips” in place of technical analysis.

We have learned that in our previous lessons, haven’t we?

The way market is behaving has nothing to do with using position sizing to calculate the position of your stop.

You are trading in the market and the best approach, in this case, seems like the movement of the market.

What you need to do is decide to place your stops before calculating your position sizes.

Placing Stops Too Wide

Most traders make the mistake of setting stops too far believing that the price will move their way.

However, it takes away the purpose of setting stops.

Setting far stops increases the amount of pip needed to move the trade in your favor.

The recommended way is to place stops closer to entry than profit targets. Obviously, you want better rewards at a lesser risk.

With a better reward to risk ratio, you are more likely to end up with profits more than 50% of the time.

Placing Stops on Support or Resistance Levels

Placing stops on resistance or support levels is also one of the crimes traders commit.

Technical analysis should be the way to determine the position of the stops.

If you’re going long, you can just look for a nearby support level below your entry and set your stop in that area.

In case you are going short, you can look for a support level closer to your entry point and you can set your stop there.

The reason why placing the stop near the support or resistance level is that there is a chance that the direction may turn in your favor.

By placing your stop beyond that area, you will lose certainty that your support or resistance is broken and the trade idea was not correct.

3 Rules To Follow When Using Stop Loss Orders

When you have completed your work and made an amazing trade plan that incorporates a stop out dimension, you presently need to ensure that you execute those stops if the market conflicts with you. There are two different ways to do that. One is by utilizing a programmed stop and another through a psychological stop.

Which one is most appropriate for you?

Here’s the place the crucial step comes in as the response to this inquiry lies in your dimension of control.

New traders in particular, regularly question themselves and lose that objectivity when the agony of losing kicks in and acquires negative musings like, “Perhaps the market will turn directly here. I should hold somewhat more and maybe the trend can go in my direction.”

On the off chance that the market has achieved your stop, your explanation behind the trade is never again substantial and it’s a great opportunity to finish it off.

This is one of the reasons why limit orders were created in the first place.

New forex traders should use limit orders to make sure that the losing trades are automatically closed out at pre-calculated levels.

This way you can save yourself from making a mistake. What more? You don’t have to sit in front of your trading station to execute the order.

Great, isn’t it?

Obviously, the more trades and experience you have added to your repertoire, the more you will ideally have a superior comprehension of market conduct, your techniques, and the more taught you will be.

At exactly that point would mental stops be alright to utilize, yet we still HIGHLY prescribe limit orders to leave most of your trades.

Physically shutting trades leaves yourself open to committing errors (particularly during unanticipated occasions, for example, entering the wrong value levels or position estimate, a power blackout, an espresso gorge instigated washroom long-distance race, and so forth.

Try not to leave your trade open to pointless risk so dependably have a limit order to back you up!

Since stops are never an unchangeable reality and you can move them, we will end this exercise with 3 principles to pursue when utilizing stop-loss orders.

3 Simple Rules to Set Stop Losses

1.Keep Your Emotions on the Side

Before you put your trade on, your stop adjustments should be calculated just like your initial stop loss.

2.Trail Your Stop

Trailing the stop means moving it in the direction of a winning trade. This locks your profits and manages your risk even if you add more units to your position.

3.Never Widen Your Stop

Increasing the stop increases your risk and the amount that you will lose. Your trade is done if your market hits your planned stop. Bear it and move on to the next trade. Each trade is a new opportunity.

Again, never widen your stop.

Setting Stops

Before we move further, let’s have a look back at the things we have studied to remember about the stop losses. Try to find a broker that allows you to trade position sizes that meet the size of your capital and risk management rules.

Always know when to get out of a trade before you open a position and this is where the term predetermined becomes mandatory to remember. Once you are in a trade and it happens to be turned into a losing one, you lose the ability to make a decision to exit the trade with a clear head. This can have a negative impact on your account balance!

Set stops for the framework, current market condition, and the trading method. Never set your exit levels to how much you wish to lose. The market forces don’t care how much you are willing to lose and it does not matter to anyone.

Try to find out the stop levels that failed your trade once so that you don’t repeat them. Again, so that you don’t repeat them!

You can use the limit orders to close out your trades. This can be a good tool in your arsenal if you use it right. And still, after all that, limit orders are as yet the best approach: genuinely fair and can be naturally executed while you are taking in some sun on the shoreline and tasting on virgin margaritas.

Just move your stop toward your benefit target. Trailing stops are great, enlarging stops are, exceptionally terrible! Like whatever else in trading, setting stop losses is more of an art that requires skill and workmanship.

Markets are dynamic, unpredictable, unstable, and a standard or condition that works today may not work tomorrow. In the event that you ceaselessly practice the right method to set stops, record and survey your manners of thinking and trade results in your diary, at that point you’ll be one bit nearer to turning into an expert risk manager!

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