Stop Losses, Love Them Or Hate Them

FX:EURUSD   Euro / U.S. Dollar
Stop losses aim to end a trade when the market goes so far in the opposite direction, that the trade idea no longer makes sense. It’s the point of invalidation. Ideally, they get hit on bad trades only and not on good trades. The area between entry point and stop loss is a zone where the trade is at a loss, but can still recover. This is not an invalidation of the trade. It’s a balancing act: place the stop orders far enough beyond your entry point to give the trade room to breathe and allow the price to rebound in the profitable direction, yet close enough to it to protect your account against a big loss in case of an invalid setup.

When you put on a trade, you take a risk. Acknowledging this means accepting this risk and quantifying it before you enter a trade. Not using a stop loss, to me signals not accepting the risk and thereby increasing it because if you don’t use a stop loss your account becomes one. I see not cutting losses early as a fear based trading error. I always try to trade another day and stops give me piece of mind. Automatic stops are even disconnection and hardware problem proof. Everything in trading is a trade off, so there are disadvantages: when it is hit and price reverses, or if its placed wrongly.

My philosophy when managing a trade is that either I am right, or I should be out. So what is the ideal place for stop losses? Trying to answer this is like searching for Columbus´ egg. And I haven’t found it yet. It’s a personal decision and I have no overarching rule. For each play in my playbook, I describe where to put the stop loss. I don’t use a fixed amount of pips; in stead I let the trade setup conditions dictate its position. With 5-point retracement structures like the Bat pattern this would be beyond the X-point (because if price moves across this level, then it was not a retracement structure and if I am not right, I should be out).

For 2618 plays this would be beyond the tops / bottoms, for channel trades beyond the trend lines and for other plays I use support and resistance levels. I always put the stop losses at a certain distance of these invalidation points, as price may pierce through them before reversing. How far they are placed from my entry point varies, depending on the timeframe and the size and configuration of the pattern I am trading. I always adjust my position size so that in each case the amount of pips from the entry point to the stop loss represents my maximum trade risk (as a fixed % of my trading capital).

As a consequence the position sizes I use vary from trade to trade but my risk does not. So, for any winning trade, how much profit I make per pip is proportional to the distance between entry point and stop loss. The placement of a stop loss also influences both the win rate and reward / risk ratio and therefore the expectancy. So its placement is absolutely key. When I am in a winning trade, I roll the stop loss in the profitable direction to lock in part of the profit, thus ensuring the winning trade does not turn into a loser. The stop loss has now become a profit protection point and the trade has become a management of profit. As a rule, I must have hit my first profit target, before I can do this manual trailing.

These risk free trades, essentially trading with the markets money, are awesome. Rolling the stops in the opposite direction is a no-go: stops can only be tightened, never widened. I can´t talk about stop losses without mentioning "stop loss hunting”. This refers to situations when the market quickly spikes and hits your stop loss so you are out with a loss, only to reverse and continue in the direction you predicted. I will not get into whether it’s the broker, the banks or institutional traders that are behind this (looking for liquidity to fill their positions), but this price behaviour does happen and taking it into account pays off.
You don´t need to be a weatherman to know which way the wind blows - B. Dylan
Personally, I cannot operate without a stop loss. The basis of money and risk management for me is predicated on knowing at least the stop. Mental stops have never worked for me because there's always a "it's going to turn around moment" that I hear in my head that makes matters worse most of the time.

Also, for me, determining the "stop loss" also gives me a clearer vision at the "take profit" target and if it's even reasonable. No point in having a 100pip SL and the market has heavy support/resistance 50pips in the direction you are trading.

Risk/reward ratios are utterly important, at least for my trading system as it allows me to be wrong more but still profit.
+1 Reply
JazzForex ReyHaynes
Well said! Thanks for sharing your view on this.
IMO the professionals can see where the stops are (either through a paid service or order types being sent) and depending on the market, the larger institutions will hunt collections of stops for adding money to the bottom line.
+1 Reply
JazzForex MarketAlly
I think you are right about this and its something to take into account when using stops.
This is such an important issue that seems be over looked so often, especially by new traders. We are drawn to trading for the limitless gain and the truly free environment, but to be successful we have to make rules for ourselves! It seems counter intuitive (at first). And not only do stops provide the vehicle to "fight another day", but it also helps us determine position size, time in trade, and gauge the worth of a trade- they are as important, or more important, than your strategy in my option. Great write up... Trading View needs stickies because this would be up there! Thanks, and happy trading.
+2 Reply
JazzForex wlrfxtrader
Very good point. In trading, the possibilities for how you go about doing it are limitless. You can see it in the many different methods and rules we all use. No 2 traders are the same, even if they follow the same strategy (like pitchforks, or harmonic trading) you will find their actual rules can be and usually are different. The same holds for how we use stops. Thanks for the kind words and your elaborate response.
Good write up. I think all successful traders are the same i.e. risk reward is correct and they are able to suffer and come back. Being able to suffer is what makes or breaks a trader. The rest is teachable.
+2 Reply
JazzForex BabushkaTrader
I have read that successful traders have similar characteristics as successful athletes in that they are elite performers who keep perfecting their skills and can overcome adversity through perseverance.
I believe that in the long term a trader has a 50% chance so the only thing that matters is your risk reward i.e. stop and profit target. Rest is fooled by randomness.
+1 Reply
wlrfxtrader BabushkaTrader
50% would be amazing! I think any given trader has about 10% chance of success- and stops are KEY. Happy trading.
+1 Reply
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