A Logical Method of Stop Placement

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A Logical Method of Stop Placement

Trading may be seen as a game of chance. This implies that every trader will be mistaken at some point. When a transaction goes awry, you have two choices: take the loss and liquidate your position, or double down and perhaps sink with the ship.

This is why employing stop orders is critical. It’s human nature for many traders to capture gains rapidly while holding on to lost transactions. We accept gains because it feels nice and we want to avoid the pain of failure. A correctly placed stop order solves this issue by serving as protection against losing too much money. A stop must answer one question in order to function properly: At what cost is your viewpoint incorrect?

In this post, we’ll look at a few methods for evaluating stop placement in forex trading that can help you swallow your pride and keep your portfolio afloat.

Key Takeaways

  • Stop orders may help any trading strategy reduce the chance of a poor deal escalating into runaway losses.
  • To utilize stops effectively, you must first understand what kind of trader you are and be conscious of your own shortcomings and talents.
  • Because every trader is unique, stop placement is not a one-size-fits-all exercise. The goal is to discover an approach that works for you.

The Hard Stop

The hard stop is one of the most basic stops, in which you simply put a stop a specified number of pips away from your entry price. However, in many circumstances, having a hard stop in a volatile market makes little sense. Why would you use the same 20-pip stop in both a tranquil and turbulent market? Similarly, why would you put the same 80 pips on the line in both calm and turbulent market conditions?

To demonstrate this concept, consider stopping the purchase of insurance. The insurance you pay is a consequence of the risk you take, whether it is for a vehicle, a house, or your life. As a consequence, a 60-year-old smoker with high cholesterol who is overweight pays more for life insurance than a 30-year-old non-smoker with normal cholesterol levels since his risks (age, weight, smoking, cholesterol) make death more probable.

ATR % Stop Method

Because the breadth of the stop is decided by the percentage of the average true range, the ATR% stop strategy may be employed by any style of trader (ATR).ATR is a measure of volatility over a certain time period. The most frequent length is 14, which is also used for oscillators like the relative strength index (RSI) and stochastics. A greater ATR represents a more volatile market, whereas a lower ATR represents a less volatile market. By employing a proportion of ATR, you guarantee that your stop is dynamic and varies in accordance with market circumstances.

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For example, the GBP/USD average daily range in the first four months of 2006 was roughly 110 pips to 140 pips (Figure 1).A day trader would choose to employ a 10% ATR stop, which means that the stop is 10% x ATR pips away from the entry price. In this case, the stop would be somewhere between 11 and 14 pips from your entry price.

As a stop, a swing trader could employ 50% or 100% of ATR. Daily ATR ranged from 150 to 180 pips in May and June of 2006. As a result, a day trader with a 10% stop would have stops from entry of 15 pips to 18 pips, but a swing trader with a 50% stop would have stops from entry of 75 pips to 90 pips.

Image by Sabrina Jiang © Investopedia2021

It only makes sense for a trader to adjust for volatility by using larger stops. How many times have you been pulled out of a turbulent market just to watch it reverse? Trading entails being shut out. It will happen, but nothing is worse than being shut out by random noise just to watch the market go in the manner you expected.

Multiple Day High/Low

The multiple day high/low strategy is ideal for swing and position traders. It is easy and requires patience, but it may also expose the trader to excessive danger. A stop would be set on a long position at a certain day’s low. Two days is a frequent parameter. In this case, a stop would be set at the two-day low (or just below it).

If a trader was long throughout the uptrend shown in Figure 2, he or she would most likely quit the position at the circled candle since it was the first bar to break below its two-day low. As this example shows, this strategy works effectively as a trailing stop for trend traders.

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Image by Sabrina Jiang © Investopedia2021

When a trader uses this strategy after a day with a wide range, he or she may take on too much risk. This result is shown in Figure 3 below.

Image by Sabrina Jiang © Investopedia2021

A trader who takes a position around the top of the enormous candle may have made a poor entry decision, but more significantly, that trader may not want to utilize the two-day low as a stop-loss technique since the risk may be high (as shown in Figure 3).

A solid entrance is the best risk management. In any event, when starting a position immediately after a day with a broad range, it is advisable to avoid the multiple day high/low stop. Long-term traders may choose to employ weeks or even months as stop placement restrictions. A two-month low stop is a big stop, but it makes sense for a position trader who only makes a few transactions a year.

You do not need to spend as much for insurance if volatility (risk) is minimal. The same is true for stops—the amount of protection you need from your stop will fluctuate with market risk.

Closes Above/Below Price Levels

Setting stops on closing above or below particular price levels is another important technique. The deal is manually closed off once it closes above/below the stated level; there is no real stop applied in the trading program. Stop price levels are often round figures ending in 00 or 50. This strategy, like the multiple day high/low method, demands patience since the transaction can only be concluded at the conclusion of the day.

Stops put on closing above or below specific price levels eliminate the possibility of getting whipsawed out of the market by stop seekers. The disadvantage here is that you cannot define the precise risk, and there is a danger that the market may break out below/above your price level, leaving you with a significant loss. To reduce the likelihood of this occurring, you should generally avoid using this kind of halt before of a major news event.

You should also avoid using this strategy while trading highly volatile pairings like GBP/JPY. For example, on December 14, 2005, GBP/JPY began at 212.36 before falling to 206.91 and ending at 208.10. (Figure 4).A trader who set a stop loss on a closing below 210.00 may have lost a lot of money.

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Indicator Stop

The indication stop is a simple trailing stop approach that works on any time frame. The goal is to get the market to show you a sign of weakness (or strength, if you’re short) before you exit. The primary advantage of this halt is patience. Because you have a trigger that pulls you out of the market, you will not get spooked out of a deal. The disadvantage, like with the other strategies discussed above, is increased risk. There is always the possibility that the market may fall during the time when it crosses below your stop trigger.

However, in the long run, this form of exit makes more sense than attempting to choose a high to leave your long or a bottom to quit your short. How many times have you quit a trade because the RSI fell below 70, only to watch the upswing continue as the RSI remained in the 70s? On a GBP/USD hourly chart in Figure 5, we utilized the RSI to demonstrate this strategy, but many other indicators may be employed. Indexed indicators like as RSI, stochastics, rate of change, or the commodities channel index are ideal for use as a stop trigger.

Image by Sabrina Jiang © Investopedia2021

The Bottom Line

Trading is always a game of chance, which implies that every trader will be incorrect at times. To utilize stops properly, every traders must first understand their individual trading style, limits, biases, and preferences.

Investopedia does not provide tax, investment, or financial advice. The material is offered without regard for any individual investor’s investing goals, risk tolerance, or financial circumstances, and may not be appropriate for all investors. Investing entails risk, including the possibility of losing money.

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