Theory: Stop Loss Placement

Theory: Stop Loss Placement
Photo by Joshua Hoehne / Unsplash

Anyone who has chatted with me or written me emails will know that one of my big things is using stop losses and the importance of them for your trading sanity.

I have many a debate about the topic, a classic conversation would go (usually from the same trader a couple of days in a row):

TraderJoe: Adam … do you think the EUR will rise today?
Akuma99: Not too sure just yet … need to wait for support to hold
TraderJoe: What about tomorrow .. you think it will rise tomorrow?
Akuma99: Well there is some US data tonight that could affect that
TraderJoe: How about by the end of the week?
Akuma99: TraderJoe are you holding a long position?
TraderJoe: Do you think it will go to 1.2300 by the end of the week?
Akuma99: What trade do you have? What was your entry?
TraderJoe: 1.2290
Akuma99: Long or short? … What was your stop loss TraderJoe?
TraderJoe: Well long, and I don’t use stop losses, I don’t like to confine my trade
Akuma99: Well there is a fair way to go before we see 1.2300, need to see if 1.2200 holds for now
TraderJoe: So you think it will rise right?

… and so it goes on, usually, every day for the rest of the week as prices make up their mind …. this is usually then followed by this conversation around a week later

TraderJoe: Hey Adam … remember me?
Akuma99: Ummm yeh sure
TraderJoe: Remember that EUR long position I had at 1.2290 last week, I closed it this morning at +10 .. see that is why I don’t use stop losses, eventually it comes around.
Akuma99: Well done :) … how did your other trades go?
TraderJoe: I didn’t take any other trades...

…. so we end that conversation with TraderJoe convinced a no-stop loss policy is the best way to go, and look if it works for TraderJoe, then all power to him, but what is the main problem with the above scenario?

… suck it up, place your stop losses and be prepared to be wrong, there is no pride to be stuck in losing trades that keep you out of the most lucrative market in the world …

The main problem with this scenario is the time!

While TraderJoe did eventually close in profit, it took him out of the market for a week.

In essence, TraderJoe traded a whole week for a +10 profit, sure his trading log looks better cause there are no minus figures this time, but the results are far from impressive and what has he learned?

For traders starting out on a highly leveraged account, as most are while they try to build an account quickly, margin calls become a real danger, so if a trade moves the wrong way and you find yourself in a trade sitting at -100, two things happen:

  1. You are locked out of the market as you risk a margin call if another trade goes the wrong way, meaning you miss a multitude of other opportunities for profitable trades
  2. You live in perpetual fear of your account being wiped out by a news event.

If TraderSally happened to be trading at the same time, with stop losses in place for all her trades, and she ended the week with 10 winning trades, and 8 losing trades, for a balance of +10 for the week, which trader do you think learned the most about trading that week?

Sure the results are the same, but down the track, I really believe TraderSally will be further down the trading road to profitability. Stop losses I think are vital to keeping your risk definable and your enjoyment levels up.

Believe me, your last losing trade is forgotten easily when you close your next profitable trade (a reason to keep trading logs).

So onto placing stop losses, there are many many theories on how to place stop losses, and rather than plowing through them all here, I’ll point you to a great article written over at Globetrader’s site here that spells it out better than I could.

Instead, I’ll just explain how I think of my stop-loss placement. I read a great comparison somewhere, likening stop-loss placement to a game of hide and seek, and it really is a very good comparison.

I ask myself three things when placing stop losses:

  1. Where can I hide my stop loss so that people won’t find it?
  2. At what point is my trade no longer valid?
  3. Where do I think things will go?

Let’s run through them:

Where can I hide my stop loss so that people won’t find it.
This is the hide-and-seek theory, there are traders, brokerage houses, and market makers out there that look for stops, don’t let anyone tell you anything different.

They look for obvious stop placement areas and push prices to them looking to trigger those stops for their own benefit. So how do you hide them?

Let’s say prices are just below what you deem as a solid resistance level, you want to place your stop just above that resistance for a short trade, and think about where all the other stops may be, most likely 1 or 2 pips above that resistance level.

In this scenario, I would place my stop loss perhaps 10 pips above that level, on a 3-pip spread pair, and look for a slightly better entry, perhaps with a stop order a pip below the resistance level to keep my risk the same.

If prices honor the resistance, then you are in with a fantastic entry and no drawdown, if they test for stops just above, you have some chance of them not finding your stop.

This is just one example, and it really is over-simplistic in a complex market, but if you have the mindset of "where can I hide so they won’t find me" while still keeping your risk levels in mind, then your stops shouldn’t get triggered so often on those trades that end up turning your way.

At what point is my trade no longer valid?

You place a trade because you believe a trade will move in a certain direction, you can picture it in your mind's eye, and you can imagine how the trade would go.

A stop loss should protect you against bad decisions, so place your stops at levels that would tell you your decision was wrong. If that point is too far away from your entry for your risk level, then perhaps you are entering the trade at the wrong time.

Where do I think things will go?

This question is brought up many times in relation to risk and reward scenarios, however, I think of it differently.

If I picture the EUR will be moving 10 pips down in the next hour, but to keep myself safe, I need to hide my stop behind a resistance level 20 pips away, then I don’t reject the trade because I don’t like the risk-reward ratio.

I reject the trade because I should actually be thinking about where to enter a long position rather than catching the tail end of a move down.

If in your mind's eye you see a pair about to retrace slightly before bouncing, take the bounce trade .. not the last bit of the retracement, if your mind's eye picture was right, you are in for a much more profitable trade.

There is nothing wrong with being wrong, it is human nature to avoid defeat, to not want to admit you are wrong.

It is more prevalent in males, which is why it wouldn’t surprise me if females made better traders, but that is a discussion for another time. What matters at the end of the trading day is your pip balance, is it positive or negative, not whether you were right or wrong.

So suck it up, place your stop losses and be prepared to be wrong, there is no pride to be stuck in losing trades that keep you out of the most lucrative market in the world, as they say … "You gotta be in it to win it".