Where to Set a Stop Loss

Where to Set the Stop Loss in your Forex Trades

6stop1270813The Stop Loss is a pending order sent to the broker from the trader’s platform to close an active position automatically if the price of the asset moves against the trader’s position by a certain number of pips.

The Stop Loss is incorporated into the platform and the trade process for a reason, which is to help stop uncontrolled losses, especially if the trader is not on his trading station to monitor the goings-on with the trade itself.

Now while the stop loss is in itself a good tool, it has been badly misused and abused by traders. There have even been instances of certain self-appointed trading gurus advising traders not to use the stop loss. Ridiculous is the only uncouth word suitable to describe such a notion. I personally demonstrated the folly of not using a stop loss on a trade by setting a position which had a limited profit target, but had no stop loss. By the time the position was checked 3 days later, it had lost close to 200 pips and erased all the scalping profits made by a trainee the previous week.

Stop Loss orders are therefore very important and if the principles of setting a stop loss are applied properly, traders will be thankful to have them.

Setting a Stop Loss (SL) Correctly

Now you will be shown two ways in which to apply or set a stop loss correctly. The first will be in trade protection mode, while the second will be in profit protection mode.

a)    Trade Protection Mode

The first method is the most commonly used method, which is to protect trades. The essence of setting the stop loss in this case is simply to protect the account from uncontrolled losses in case the trade goes against the trader. The key is to set the stop loss in such a way that it does not prove to be too tight, and also not too generous as to scandalously allow a trade to go really bad before it gets to work.

The best way to do this is to always set a stop loss just below a support level or just above a resistance point. The work to be done here is therefore to identify the support and resistance levels before entering the trades. This way, stops are not set arbitrarily.

Support and resistance can be formed by price action highs and lows (see chart below) or pivot points. Even chart patterns and Donchian price channels can clearly show support and resistance because they are demarcated by trend lines.

Take a look at the snapshot below, which shows price action support levels.

setting stop loss

We can see that a previous support had formed, demarcated by the dotted red line. This is to be used as the benchmark for future attempts at a long trade. Sometime later, we see that the price action got down to the support and failed to break it. This is definitely a good place to go long. Now because the price actually failed to break support, it is safe to set the stop loss a few pips below this area. This makes the stop loss tight enough (thereby reducing the risk factor in the trade), but not too tight. In any case, if price actually breaks support by closing below this line, then the bias in the market has changed to a bearish one and the price action will surely drop hard. This is where your stop would serve to protect you from enduring more losses.

The principle behind using the stop loss as just described assumes that when the asset is trending, an opposition to this movement is a minor retracement which will be rejected at a key level, preventing the stop loss from being triggered.

b)    Profit Protection

The stop loss can also be used as a profit protection tool. In this case, the trade must have first moved into profit territory. Half or two-thirds of the position is then closed in profit, and the stop loss is moved from the default negative position to the breakeven point. Some may even choose to define it as a trailing stop, chasing the profitable trade from a profit position, and locking up the profit if the trade makes a contrary move.

This tactic is very useful when the trade is approaching the opposing key level, but the trader strongly suspects that the momentum in the trade will force a break of the key level.

setting stop loss 2

The snapshot illustrates this very clearly. The support line is clearly established, so the trader can go long at the area marked “long entry”. The stop loss is set a little below the support.

Now watch the price action as it moved to the 1st Take Profit (TP) zone. This is where half the position is closed in profit. The stop loss can then be moved to breakeven or beyond, while the remaining open position chases the market higher. It may not always be the case that the market continues in its advance, but at least the stop loss would have done its job.

This in a nutshell, is where and how to set the stop loss.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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