In this article, Chris Pulver – Senior Currency Strategist at Market Traders Institute – offers some insights into how you can set effective stop losses based on price confirmations. To know more about the systems, tricks, and strategies that Chris uses to target potentially profitable trades, you can download his free ebook here.
While many traders are fixated on the profits made, experienced traders know well how protecting the downside or capping losses is imperative.
The reason is because trading the market is filled with volatility and therefore it becomes important to have some risk-management mechanism in place. One such widely-used mechanism for reducing risk exposure is the stop loss.
Simply put, a stop loss order is an automated risk-management instruction set by traders with their brokers to sell a specific security once the price of it falls or rises to a pre-specified level.
Let’s say you’re trading a stock XYZ, which you bought at $100, and you don’t want to hold it if the price falls below $90. This is the level where you will place your stop loss to protect the trade from incurring further losses.
While stop losses can help you target the trades you want to make, many traders follow them the wrong way.
They find prices of a security spiking up to highs and lows to find stops and then proceed in the reverse direction they wanted to trade. That not only leaves them with losses but also limits their profit potential. This is a typical example of something called ‘stop hunting’.
So, let’s talk about how one can effectively determine stop loss levels and avoid falling victim to ‘stop hunting’…
Avoid Stops at Support and Resistance Levels
One simple way to set a proper stop loss so you don’t get stopped out too early is to avoid placing your stops just below the support or above the resistance levels.
Why?
Because that’s where most of the traders place their stop loss. Plus, it also incentivizes the big institutional traders to push the price to those levels as it likely offers them better entry and exit points on their trades.
Here’s how you can tackle this situation instead…
Stop Loss with Price Confirmation and Alerts
Let’s say you are trading the EURNZD currency pair and planning to buy it at the 1.6800 levels. The chart shows you there are two stops you can place for this trade which are the recent lows for EURNZD. These are placed at around 1.65 levels and at 1.63 levels as shown in the image below.
Buy Trade On EURNZD
Source: SmartTrader, Market Traders Institute
So, the setup for this trade is to close the trade in case it falls to these stops. However, what we would be doing is stay put in the trade as long as the price doesn’t close below these stops.
What we are doing here is waiting for the price to confirm if it’s going to fall further or will it bounce back towards our target levels.
A simple hack to keep a track of this is to place a trade alert at our stop levels. This lets us know when the price touches the stop.
So, for the EURNZD trade, we can set an alarm at the stop of 1.65 levels. Once the price touches it and we’re alerted, we wait to confirm if it is closing below 1.65. If the price does close below, we can exit the trade.
However, if the price has touched 1.65 levels but doesn’t close below it, we believe the best approach is to stay in the trade as chances are that it might bounce back towards our target.
The same strategy applies to stops placed above resistance levels where you’re looking to sell a security.
Say if your trade on EURNZD was successful and you made profits by closing your Buy trade at high levels. What you can do next is to have a Sell trade on the currency pair.
Let’s say the pair is trading at the high of 1.75 levels and we’re now looking to sell it in anticipation that the price will make a U-turn and fall from recent highs.
In this case, our stop will be placed at the recent high which is the resistance level of 1.75, as seen in the image below.
Sell Trade On EURNZD
Source: SmartTrader, Market Traders Institute
For this trade, we will set an alert at a stop of 1.75 levels. Once the price touches the stop level and we’re alerted, we wait to confirm if it is closing above 1.75. If the price closes above it, we can exit the trade. On the other hand, if the price doesn’t close above our stop, the best approach is to stay in the trade as chances are that it might fall back towards our target levels.
So, to quickly wrap it up, here are the three points to consider while trading with stop loss orders:
- Set your stop loss at a distance away from the support or resistance level.
- If you’re in a Buy trade, do not close the trade (or let the stop loss trigger) as long as the price doesn’t close below the support level.
- If you’re in a Sell trade, do not close the trade as long as the price doesn’t close above the resistance level.
This strategy can help ensure we do not close a trade too early unless the price confirms a strong price rejection. That way, we can avoid unwanted losses and let our trades run for higher potential profits.
In conclusion, knowing the difference where you trigger your stop losses can go a long way in having a sound and potentially rewarding market strategy.
In fact, we’ll go on to say that it’s one of the risk management techniques that can separate successful traders from average traders.
Senior Currency Strategist, Chris Pulver, has recorded a short video around this topic, where he explains more on the concept. Click here to watch this timeless lesson>>
And to discover simple to apply, time-tested, and potentially profitable Forex strategies, download our FREE ebook and learn how you could avoid some critical trading mistakes.
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