There is one question in trading which gives headaches to many traders: How to Determine Stop Loss in Forex?
It seems easy – traders should place stop loss for each position when they trade. The key manner to provide the assurance that the account does not undergo such a damaging situation is to apply the usage of an order for stop-loss that will provide limitations concerning the level of exposure to risk factors. But having the knowledge regarding where to place an order for stop loss pertaining to each trade is not considered to be ample in order to make you a trader that is profitable. This based on the premise that it is also needful to possess the correct size in regard to the distance of a designated stop loss in order to permit you to remain for an extended period in the trade session in order to view the movement of the price in the direction that you select.
What is the problem when determining the stop-loss of a position?
The downside is that there does not exist any easy answer concerning the spot where you should place the stop loss when you are engaging in forex trading.
There is no clear consensus on how to determine a stop-loss price level for exact trade. The largest group of traders advises that the stop loss should be set as close to the entry-level as possible (tight stop-loss), while the other group suggests a greater stop loss distance (wider stop-loss).
Problem Solving: How to Determine Stop Loss in Forex?
First, let us see the easy part. How we can place stop loss in the Metatrader platform?
In this video below we can learn what is stop loss and how to set stop-loss:
In the image below you can see how to place stop-loss orders and modify stop-loss orders in the MT4 platform:
In the image below is described process of stop-loss placing in MT4 Android platform:
Now let us see what theory says.
Stop-loss is a brilliant tool that can help you in protecting your investment. Once you learn all about the key levels, you can easily define price action strategies and find out a risk-reward ratio that is suitable for you. Once everything is set, it is time to use a stop-loss to take your trading style to a different level.
Principles to apply:
The stop-loss price level can be set based on previous low or high (or Fibonacci levels).
It cannot be denied that there are various principles which you should apply for guidance when you are making decisions in regard to the placement of a stop loss. You may engage in the application of a particular principle when you are conducting trade in the long term, like a swing trade. But then you may decide to apply yet a diverse principle when you are conducting a trade that is classified as being intraday. The principles that we mention will function well when they are utilized in a precise manner with the proper type of trade.
Important price levels are the best approach to determine the stop-loss level. Previous high or previous low or Fibonacci levels are excellent entry, stop loss, and target levels. For example, traders can BUY a currency pair if the price is above yesterday’s high. The excellent stop loss value can be yesterday’s low price level.
A stop loss should be placed where there will be the invalidation of your trade perception.
This principle is noted as being the primary one that consideration must be given to at all times when you are making the decision in regard to the spot for the placement of your stop. If you are conducting trade in the long term, you should attempt to ensure the placement of the stop loss in such a situation that when the price achieves its level, then trade in the long term would not be feasible. In other words, your stop loss must experience placement at a spot when the price achieves its level, this sets up the trade in the long term and experiences invalidation. This allows you to have space for the setting up of trades in the short term.
The Stop-loss level can be determined as a trend invalidation price level. For example, If the trader’s analysis shows that the bullish invalidation level is between 1.3 till 1.303 price level range, in that price range stop-loss can be set. Usually price invalidation level can be moving average. For example, if the daily close is above some important price level it is a bearish invalidation price level. If the daily close is below some important price level it is a bullish invalidation price level.
Trader BUY EURUSD at 1.35 when the daily close is above SMA200.
After 5 days the price is at 1.38 and SMA200=1.365.
A trader can move stop loss at 1.365 and set SMA200 as the stop-loss price level.
It is noted that this is also true concerning trades in the short term in such cases that there is the placement of an order for stop loss at a spot that when the price is achieved, this results in the changing of the prince trend. This means that there is no longer support for a trade in the short term but rather trade in the long term. Due to the reality that this is the primary and most relevant principle in terms of giving consideration to the placement of an order for a stop loss, it is needful for you to think of it first prior to applying the usage of other factors and principles.
Risk reward ratio and stop-loss – Consideration is given to the ratio for the risk in comparison to the reward.
Recently, we explained the risk reward ratio. This principle is regarded as being the one that is second in terms of a high level of importance in such cases that you are making a decision about where the placement of your stop loss should be. A great majority of traders hold the preference of entering into the conducting of trades that possess a ratio for the risk in comparison to the rewards being 1:2. This indicates that for the risk of each dollar (pip), there is the possibility to result in gaining two dollars (2 pips) in such cases that the trade is directed in their favor. It is noted that this ratio pertaining to the risk in comparison to the rewards is not the only one that you can apply due to the reality that there are some setups for trades that may permit you to opt for a ratio for the risk in comparison to the reward at a rate of 1:5. Moreover, there is an even smaller ratio possible for risk in comparison to reward at a rate of 1:1.5 based on where your entrance into a trade is as well as your possible target. Read more about stop-loss and take profit in our article.
When you are careful to apply this principle, it is imperative for the placement of your stop loss to be situated in such a manner, so that it will permit you to attain your possible target based on the setup of the trade.
Take into consideration, for example, that if you are conducting trade for the sake of a breakout that has the possibility of collecting one hundred pips in such a case that this is noted as being the amount of distance to get to the following level of support, you could dare to engage in the risking of fifty pips for this particular trade in order to the opportunity to collect a profit of one hundred pips, which is regarded as a rather substantial ratio of 1:2 for risk in comparison to reward.
Thus, it is realized that this same type of rationale is administered in such cases that there is the targeting of pips that are less. It is noted that there could be the impact of the placement of the stop loss in an effort to preserve the ratio preference in terms of risk in comparison to reward.
Caution must be taken
It is the tendency for a large number of traders to have a fixation regarding the ratios of their risk in comparison to reward. The fixations can be so strong that they fail to give heed to the first principle in how to place the stop loss at a spot where the trade idea will experience invalidation in such a case that the price reaches the designated level.
It is wise to avert engaging in the placement of a stop loss at distances that are noticeably short in order to augment the ratio for the risk in comparison to the reward at the sacrifice of permitting the grade ample space to be directed for your benefit.
While there is no stop-loss strategy that will work exactly the same for every trader, here are some tried and tested ones that you can use or learn from:
1. Pin Bar and Inside Bar
Every trader can set the stop-loss as they see fit but there are some places that are recommended by experienced traders and brokers. For the pin bar strategy, irrespective of whether the market is bearish or bullish, the stop-loss must be placed behind the pin bar tail. The pin bar trade will become invalid as the prices hit the stop-loss there. This proves that traders must not panic when prices hit the stop-loss. It is not always a negative thing. This is the market’s way of telling you that you need to set a stringer pin bar.
If we compare the pin bar strategy with the inside bar FX trading, the latter offers two options for the placement of a stop-loss. You can place it behind the inside bar’s low or high, or the mother bar’s low or high. The second option is safer. Just like in the pin bar strategy, if the prices hit the inside bar, the trade will be rendered invalid. This is considered a safer strategy due to a larger difference between the entry and the stop-loss. If you are trading a choppier currency pair, the buffer created by this strategy will allow you to stay in the trade for a substantial period of time.
The placement of a stop-loss behind the inside bar’s low or high is beneficial as it offers a better risk-reward ratio. The negative of this strategy is that your trade can be stopped even before it gets the chance to reach its full potential of ending in your favor.
While the second option is riskier because of less difference between the entry point and the stop-loss, which strategy will be more suitable for you will still depend on your overall trading strategy, risk tolerance, the currency pair that you are trading, and other factors.
2. The Set and Forget
The set and forget stop-loss strategy or the hand-off strategy is very simple to understand. The trader has to decide where to put the stop-loss and once they have done it, just let the market move as it feels. Unlike the previous strategy where you were susceptible to getting stopped before the trade could move, this strategy mitigates that problem by retaining the stop-loss at a safe distance.
Investors and long term position traders use the “Set and Forget” strategy very often. Usually, they risk less than 0.5% from their portfolio, put wide stop-loss and wide targets, and do not change stop-loss sometimes several weeks or months.
Traders feel liberated when they use this hands-off strategy as they are not required to keep a constant eye on their strop-loss. You give the market a chance to run its course while you sit back and watch it happen. As it is simple to understand and does not require constant attention, it is perfect for novice traders.
One of the most prominent drawbacks of this strategy is the maximum allowable risk that persists from start to end. This means that when you put a part of your capital at risk, you actually stand a chance to lose it should the market does not move in your favor. From when you enter the trade and close, you don’t get the opportunity to protect your capital. Once you have set the stop-loss, it will run its course.
The other disadvantage of this strategy is that you can be tempted to move your stop-loss. This is not is human nature to sit idle when their money is on the line. As the strategy works well when you set the stop-loss and forget about it, many traders will not be able to do this.
3. Move a Stop Loss to Breakeven
This strategy is different than the other two is because the traders can finally allow the market to help them in organizing a strategy. They can read the market vans analyze the amount of capital that they need to defend. You can use the 50% strategy on a pin bar setup. Let’s assume that you enter a bullish pin bar when it’s time for a daily close or entry. The market finishes a little higher the following day than your entry.
Like every other strategy, this one isn’t perfect either. It offers protection to only half of your investment while the other half is at risk. This can sit differently with different traders. We cannot consider it an actual downside as some traders prefer to take this risk. If you are one of them, this strategy will be perfect for you.
However, the risk of trade stopping prematurely is still there, especially if you are trading a choppier currency. Since the market plays a crucial role in this strategy, whether your stop-loss strategy is acceptable or not will also be decided by the Forex market.
Considering the same example as used above, had the market closed around the low on the second day, this strategy would not have worked. This is because the stop-loss would have moved too close to the prevailing market prices. If you are in such a situation, a better option would be to leave the stop-loss at its original position. The 50% stop-loss strategy becomes riskier when trading an inside bar.
How do I set stop-loss?
In the first step,