Forex Trading Course: Chapter 14: Forex Stop Loss Strategy
For instance, if you are in a swing trade and you know that EUR/USD has moved around 100 pips a day over the past month, setting your stop to 20 pips will probably get you stopped out too early on a small intraday move against you.
Knowing the average volatility helps you set your stops to give your trade a little breathing room and a chance to be right.
Method #1: Bollinger Bands
As we explained in a previous lesson, one way to measure volatility is by using Bollinger Bands.
You can use Bollinger bands to give you an idea of how volatile the market is right now.
This can be particularly useful if you are doing some range trading. Simply set your stop beyond the bands.
If price hits this point, it means volatility is picking up and a breakout could be in play.
Method #2: Average True Range (ATR)
Another way to find the average volatility is using the Average True Range (ATR) indicator.
This is a common indicator that can be found on most charting platforms, and it’s really easy to use.
All the ATR requires is that you input the “period” or amount of bars, candlesticks, or time it looks back to calculate the average range.
For example, if you are looking at a daily chart, and you input “20” into the settings, then the ATR indicator will magically calculate the average range for the pair over the past 20 days.
Or if you are looking at an hourly chart and you input 50 into the settings, then the ATR indicator will show you the average movement of the last 50 hours. Pretty sweet, huh?
This process can be applied by itself as a stop or in conjunction with other stop loss techniques.
The point is to give your trade enough breathing room for fluctuations here and there before it heads your way… and hopefully, it does.
New traders should allow the market to hit their original stop loss or target: “set it and forget it.” Actively managing trades complicates the trading process and can induce a lot of emotion which new traders may not have the skill set to deal with. That said, some basic stop loss management is acceptable, such as reducing risk once a trade is closing in on the profit target.
Only move a stop loss to reduce risk or lock in profits. Never move a stop loss to accommodate a growing loss hoping it will turn around if you give it more room!
While I often just get out of trades at my stop loss or target, I also have some guidelines that allow me to alter my stop loss or target during a trade, or alter my exit plan.
- If day trading, I get out of a trade about 2 minutes before a major economic news announcement.
- If swing trading, I get out of a trade if the current price is close to my stop loss or target and a major economic news announcement is coming out soon.
- Stop loss may be moved to near breakeven once a trade is 50% of the way to the target.
- Stop loss may be moved in further, guaranteeing a profit, once the price moves 75% of the way to the target.
- At the outset of some trades, I determine that I will use a trailing stop loss. As the price moves favorably, I move my stop loss to lock in profit in alignment with the trailing stop loss strategy.
- If I happen to be watching a trade and the price is very close to the target, but hasn’t hit the target, I manually get out immediately.
How to Calculate Stop Loss in Forex: VAR (Value At Risk)
If you decide to use a stop loss then you can control exactly the maximum amount of money that you can lose for every trade – this is called the value at risk (VAR). To calculate your VAR, simply multiply the stop loss with your pip value. For example, let us go back to our first EUR/USD trade, where we set a 20 pips stop (buy at 1.4000, S/L at 1.3980). If you trade one lot, then every pip is worth $10. Hence, $10 X 20 = $200, this is your VAR.
To properly manage your risk, it is standard practice that your VAR does not exceed 2% of your balance. For a $200 VAR, we need a balance of at least $10,000. A typical mistake is to always use the same position size no matter what the stop loss is. The recommended approach is to set the stop loss level then calculate the position size.
Safety Multiple
Safety multiple can be considered to be one of the key features of one volatility stop loss.
Volatility measure can also be considered as the price tendencies of the market’s objective calculation. Similarly, safety multiple can be considered as the subjective inclusion from traders.
A low-multiple usually means one tight stop loss, which places risk-control above the potential of profit. A high-multiple produces a stop loss, which can risk more but at the same time, can offer a bigger room to breathe to the market.
This means the multiple can reflect the expectations of the trader of the price action.
Two and three are commonly used safety multiples that are used in the volatility stop losses. These can also be used as the starting point by the trader to experiment.
The ideal approach will be to extract one default multiple that is based on back testing the markets. Then, a trader can refine them according to each trading setup’s circumstances.
For example, for a long-term trend following the trade, a higher-multiple can be a good idea. Similarly, a low-multiple is suitable for a break-out trade, which a trader is expecting to hit his/her target swiftly.
Time -based stops
The time-based stop loss approach can also be used in addition to the confluence and/or volatility stop. It is more a dynamic variable of stop loss placement, rather than a stand-alone technique which helps traders put price and their trade in relation to the markets.
How often did you enter a buy trade, but nothing happened for hours afterwards and price just hovered around your entry price? If you bought a stock and anticipated higher and rising prices, but nothing happened and your trade just goes nowhere, it is very likely that your trade idea is not working out. In such cases, traders would do better to exit their trade and wait for the next trade signal, rather than wait and hope that price starts doing something. A time-based stop loss approach would suggest exiting trades with long phases of inactivity and sideways movement.
Another example where a time-based stop can be useful is when you enter a trade and it goes against you right away. If you bought a stock because a price action pattern or other technical triggers suggested higher prices, but the trade doesn’t unfold as anticipated, it’s usually a better idea to just exit the trade. The old saying goes that cutting losses is important, but it’s more important to know WHEN to cut your losses; a time-based stop is the tool can help you here.
A time-based stop loss helps you avoid being exposed to uncertain and other-than-expected trade scenarios. Never forget what your original analysis and your trade idea was once you are in a trade.
Final Word on Using Stop Loss Orders
With day trading and swing trading, control risk. Use a stop loss! A stop loss helps determine our position size. My method is to place a stop loss at the point closest to my entry point that won’t get triggered if my analysis and expectation is correct. This typically puts my stop loss just outside the opposite side of a consolidation from my entry. When I am wrong, I am wrong small.
Letting the price hit your stop loss or target is recommended when you are starting out; don’t intervene in your trades while they underway. As you improve, and you have the discipline to let the price hit your stop loss or target, then consider managing your stop loss while in a trade to potentially improve performance. Actively managing won’t always result in greater profits though. If letting the price hit your stop loss and target works for you, don’t mess with it.
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