How to Correctly Position Your Stop Losses
Hello traders! Welcome to the Price Action Course and the seventh module, ‘Trade Management.’ In this lesson we’re going to teach you how to correctly position your stop losses. You’re going to learn throughout this lesson how important this is. In fact, this is one of the most important things you have to learn if you want to be a profitable trader. Because it doesn’t matter if you learn how to spot an entry, how to read a price action, how to trade price action and how to read order flow in the market. It doesn’t matter if you have an excellent trade idea because if you place your stops too tight or if you place your stop incorrectly, you’re going to be constantly getting stopped out of your trades. And if you are getting stopped out constantly, this means that you are going to be incurring losses constantly and this means that you are going to be an unprofitable trader in the long term, even if your trade ideas are good.
Let’s go through what we mean when we say to correctly stop your stop losses. Now, one of the most important things about being a successful trader is to be able to correctly position your stop losses. The reason is that if you use stops that are too tight, you are going to get stopped out very often, even if your idea is good and eventually the market moves your way. Being stopped out would mean that you would incur a loss on that particular trade and if you get stopped out constantly, your equity curve will always have a negative angle, which means that you will be losing money in the long run. Even if you apply everything you have learned so far correctly but failed on your stop placements, you are going to be an unprofitable trader.
The key here is to read the market, to read price action, and to know where the level that invalidates your trade idea are. This is key. This is what’s most important when we are analyzing where to position our stop losses. When you get the idea of the trade or after you correctly assess price action and you have a trade setup, you need to analyse where the levels that invalidate that idea are. And you are going to place your stops above or below those levels. The risk is always the same. What changes is your position size, according to the amount of pips that you must risk in order to make this a profitable position in the long run. Now this is also important. What I’m trying to say here is that your risk percentage is going to be always the same. If you have a risk management rule of 2%, you are always going to risk 2% per trade.
After you have the trade setup and you have your entry levels, you are going to analyse price action to know where your stops are going to be. Then you are going to calculate how long your stops are going to be and based on that, you are going to choose the position size that enables you to risk 2% of your account, for example. Your position sizes are going to be calculated vis a vis your risk or your stop loss levels, or how wide your stops are. The tighter the stops, the bigger the position; the wider the stops, the smaller the position is going to be.
The overall rules for correctly positioning your stop losses are: in a long position you place your stops below the previous lows and in a short position you place your stops above the previous highs. And why is that? Because if you are taking a long position on a trend-trading setup, if price goes against you and breaks with the previous lows, it’s going to break with the up structure, thus, you have to get out of the trade. And the same goes for a short position; if you take a short position on a down move and price goes against your way and takes out the previous highs, this means that the down structure is no longer valid and that means you have to get out of the trade. And this is what I’m talking about or what I’m trying to make you understand; you have to read price action and you have to understand where the levels that invalidate your trade idea are. Normally those levels are going to be where the structure breaks. If you are going short on a down move, if you’re going to place your stops where price breaks with the down structure. These are very broad guidelines and each position should be analyzed by itself because sometimes we’re going to be countertrend trading and you can’t place your stops above the previous high at the top of a move or below the previous low at the low of the move.
Always look for the level that will invalidate your trade idea. Always look to place your stops a few pips from these areas because they might get re-tested. This is very crucial too. If you place your stops right at the area that invalidates your trade idea, you might get stopped out if price tests this area back. So you have to play with a wider stop because you don’t want to get filled on your stops just from the re-test of the area. And you don’t want to get filled on your stops just to see price bounce from those areas and go your way on a 100 pip rally.
Never use a fixed amount of pips for a stop. This is by far the worse stop placement method there is. A lot of traders out there are going to tell you, “What you need to do is when you go long, you always risk 20 pips and you always target 40 pips, so you always get a 1:2 risk-to-reward ratio.” And this is not correct because if you use a fixed amount of pips for a stop, you are disregarding price action. The market and everything we have touched so far. This means that you are not looking for a place or for a level that invalidates your idea but you are just looking for a tight stop and a quick profit. And this is not what we’re doing here. What we’re doing here is reading the market, reading price action, and placing your stops where price will invalidate your idea. And by doing so, we are giving our trade some room to breath in order for it to go our way. Remember that the markets are not always fast to move in your direction. Sometimes there are going to be trades that go against you before eventually going your way.
What we’re going to do here, we’re going to go through a chart and a few setups and some stop placements so you can get a better idea of what we’re talking about here and how to read for levels that invalidate trade ideas.
Right here we have the GBP/USD four-hour chart and we’re going to start with a nice KYM setup, okay? We do have a strong level of resistance here. You can see that it was tested once, twice and let’s say that we are just waiting for price action to test again this area of resistance or to break it to the upside. You can see that right here we have some momentum to the upside but it was a fake-out and even though it was a fake-out, it’s a fake-out that we cannot trade because this candle is not engulfed in the previous candle. But right now we are just focusing on this area right here. So price eventually breaks to the upside. We see some ‘momo’ or some momentum, you can see that the candles go bigger and bigger and then the momentum starts to fade away and we have some profit taking. If you see correctly, we have some profit taking right here at the fill of this gap — this unfilled gap. And always look for unfilled gaps… well, not always look for unfilled gaps but if you do have an unfilled gap, take a very close look at the area as a possible area of support or resistance. You can see that right here price actually stops at this area when the gap is filled and then comes down. The actual setup that I’m looking at is this one right here, when price tests this area of previously broken resistance and support and rejects it.
Of course, some of you might think that the correct placement for the stops would be a few pips below this low. And it’s not untrue, but this is just too tight of a stop. Remember that an area of support and resistance is just not a straight line but an entire area of price, so we have to place our stops according to the structure that price is following. And right here you can see that we made a high, a low, a higher high, a higher low, a higher high, a higher low, and we are looking for a higher high. So if we break with this low right here, it would mean that the up structure which we are working on is going to be broken and our long position is no longer valid. So our stops should go a few pips below this low at a 77 pip stop loss. Remember because we are in an up structure, we can start taking profit at the top of the previous swing, which would be right here for a first target of 110 pips. As you can see, even with a wide stop we still have a better than 1:2 risk-to-reward ratio. And this is what we’re talking about. Always look for the price structure and always look for levels. In this case we did break with the previously tested level of resistance and re-tested it back, but if we had placed our stops just below the low of the candle that we were trading from, our stops would have been too tight because price could have made this. It could have come back and re-tested this area and then move back up.
Let me just get rid of this and let me position correctly this line. So this is very, very possible guys, and the overall structure would have held even if price would have tested this lows right here and the reason it could have tested this lows is because you can see that we do have some resistance at these zones. And it was re-tested again and again and again. So the actual zone is this one and you can see that we broke with it, re-tested it, then we have an indecision candle and morning star and then we have another setup. And if we are looking for that setup exactly, the setup of this morning star at the break, and this is a very, very good example actually because you can see that we do have the “momo” breakout and we are not looking for the “momo” breakout, we are looking for a very nice KYM setup and after the KYM setup we do have an indecision candle and this is the most intensive indecision candle because it has a flat body and it is right at the previously broken area of resistance, now testing in a support, then we have a nice setup right here. And of course the actual stop loss should go below the previous lows because we are an up structure and right here we would have had a very nice 80 pip stop for a gap-filled trade; again with the gap fill, a gap-filled trade of a 117 pips.
And that’s how you place your stops and if you want right now we could actually go through an example of a trade that would have stopped out traders with bad placement methods. Let’s go very quickly through this position right here. You can see that price tested this area as a support and we do have what seems to be a very nice area of resistance that price is going to test now. If you are trading with single candlestick formations, some traders would have just started a short position right after this hammer and would have positioned their stop losses right here, just above the levels. Because in their minds, if price breaks through this level, my short position is no longer valid and that could seem like a reasonable placement but it’s not. We are in a very strong down move, you can see right here. We are making lower highs, lower highs, and lower lows. And right here we are still making a lower high. So we are still in a down move or in a down structure. If we break with this high right here, which is the previous swing high, the short idea would be invalid because the market would have rolled over.
What you need to do is just wait for price action to reach this zone and you can go short after the indecision candle and this other red candle, which would mean that you would have had a nice 78 pip stop loss for a possible win of 227 pips. If you place your stops too tight, you are going to get constantly stopped out and if you are not patient enough, you also are going to be constantly getting stopped out.