By John, TradingSpotSilver.com
For most traders and especially with beginners, using stop losses in their trades might at times seem like a difficult principle to follow. The idea of allowing enough ‘breathing space’ for a trade before moving in the intended direction is a thought that is tempting enough to trade with no stops at all. However, more often than not, this (trading without stops) is in fact one of the key reasons why most traders tend to blow up their accounts.
Stops are for a reason and the ones who ignore it are either not serious or just don’t know how to use them. But fret not. I will divide the subject of stop loss into two articles, wherein, in this first article, I’ll explain the concept of stops and how to use them… even at times when you think using stops is futile and in the second part, I will cover the aspect of how to use stop losses to break even on your trades and compliment your take profits.
But first let’s understand what a stop loss is in forex trading.
A stop loss is nothing but a way of telling your broker to close your trade if price hits your stop price. In other words, using stop loss, you limit the risk exposure to your capital. Stop Loss is one of the most basic aspects of a trade (besides Take Profit). If you often wonder why you need to use a stop, then you are just not trading right, but rather gambling… taking a chance with your trade. I find this similar to playing poker when a player goes all in. It’s either a hit or a miss. Making such blind calls in forex doesn’t get you too far.
In forex you aren’t trading against another trader but with the markets. Bear in mind, the entities that make up the markets. Big institutional players that are the primary reason for bringing liquidity to the markets, the central banks and their monetary policies that are fundamentally responsible for currency exchange rates, the governments and the economic policies and many more aspects.
So when you are trading without a stop, you are in a way swimming in a sea without any support to bail you out against the ‘sharks’ and believe me, they (institutional traders) are called ‘sharks’ for a reason.
There are many key elements to a successful trading strategy… money management being one of them, and let’s not forget, using stop loss and take profits. So let’s dig a bit deeper into this concept of using stops. We’ll explore different ideas on how to use stops in order to trade better, now that we have an idea of what stops are in forex and why you should not trade without a stop loss.
Trading with Stops
Currency traders can be classified into two types; those who ‘chase the price’ and the ones who ‘wait for the price’. Obvious from this, traders who wait for price to come to them are those who use stops and take profits (and are more successful in setting their stop losses and take profits) while the ones who ‘chase price’ are the kind of traders who lose out most of the time… and the few who do set up stop losses while chasing the markets quite often see their trades being stopped out due to price hitting their
stop levels.
So what is the best approach to using stops?
Understanding risk – If you are trading with a capital of $1000, and your risk is 2%, in effect you are exposing no more than $20 for a particular trade. Convert this into pips, by taking the example of EURUSD and your stop would be set 20 pips away from your entry. But what do you do if price is moving closer and closer to your stop loss? There are only two possible outcomes; either price is indeed reversing or just retracing. If price did take out your stop loss level, you just prevented exposing all of your capital and in way managed to limit your losses on this particular losing trade.
Waiting for price – If you think chasing price is the only way to success, then you are mistaken. Let’s not get this confused with riding the trend, that’s a different story. Chasing price is when you see a couple of bullish or bearish candlesticks and think to yourself that it would be a great opportunity to place an order immediately.
As we know, price is unpredictable and chasing this is akin to a wild goose chase. Using stops in such situations (unless you really know what you are doing) results in the market eating up your capital rather than you feeding off it.
Volatility – Ever noticed some really big bullish or bearish bars, especially during the US trading session when some economic news is being released? Well, stops basically help to minimize your losses during such events when the market does a U-turn and comes back to bite you. Using stops softens the landing which at times can leave a bad taste in the mouth.
Tips for using stops effectively
In real time trading we know that things are not set in stone and most often, you might see price move a few pips or even more against your entry before going back in the intended direction. Being stopped out on such a trade would only leave you beating yourself up, potentially resulting in some impulsive revenge trades, which we all know only results in more damage than anything else. So here are some tips to follow on how to use stops effectively.
Good analysis results in more realistic stop levels
Forex trading is 99% planning and 1% execution. The moment your trade is executed, you are at the mercy of the markets. Therefore it is imperative to spend more time studying the market than to jump in impulsively. A good analysis often results in better stop losses, the kind of stops that don’t get hit, and in the event they do indicate a price reversal.
Support and Resistance to the rescue.. when everything else fails
The very basic, simple concept in forex trading that is often overlooked is support and resistance. Identifying the strong support and resistance levels is a great way to set up your stop loss (and take profit levels). There are different ways to do this. Some traders simply plot the levels on a chart as if it was second nature (which requires lot of experience and practice), but if this is something you are not very comfortable with, then there are many free tools available for you. To point some out:
- Daily Pivot Points (including Monthly/Weekly Pivots)
- Fibonacci Levels
I conclude my first part of the article covering stop losses. So far we understand that trading without a stop loss is a recipe for suicide (for your capital). Stop losses, while might seem like a pain at times, helps us to limit our risks against adverse price movements. In my next part, I’ll cover the subject of how you can use stop losses and in fact use them to compliment your trading system/style as well as working in conjunction with your take profit levels.
About the Author
John is a full time forex trader and contributes regularly to tradingspotsilver.com, a blog focused on trading systems, trade analysis and MT4 tutorials.
See Part 2: Forex Stop Losses – Trailing Your Stops to Lock Your Profits
