Major difficulties can be encountered, however, when traders determine where exactly those stop losses should be placed. If stops are placed to far away, excessive losses could be encountered (and, by extension, removing some of the benefits associated with using stop losses in the first place). Conversely, if stops are placed too close, a disproportionate number of trades will be closed at a loss. This can be especially disheartening when prices later reverse and create a scenario where your trades would have been profitable in your stop loss placement had been better positioned.
Finding a Broad Approach
For all of these reasons, stop loss placement is a delicate practice. To further complicate things, there is a large variety of very different ways to determine where trades should be closed in order to prevent further losses (your stop loss level). Stop losses can be either defined or methodical, but it is not necessary to use a single method for all market situations. The most successful traders are the ones that are able to assess the broader environment and adapt their trading plans accordingly.
The first element to consider is your initial position size. Many traders will scale into positions (rather than placing their entire trade amount at one level). Then, if prices work against you, it is possible to add to the trade size and improve on the average price paid for the trade. In these cases, stop losses will generally be farther out than if traders place the entire position size at once because the trader is already operating on the assumption prices might continue to move in an adverse direction.
Furthermore, short-term traders are usually better off exiting trades on impulsive moves, whereas long-term traders tend to look for signs that the underlying trend has reached completion. Most strategies recommend that traders never risk more than 5% of their account size at any one time, while others with a more conservative approach will take this number down to 2-3%. Here, we will look at some of the methods that can be used to set stop loss levels and protect your trading accounts in the process.
Hard Stops
Traders determine places for stop (defining an exit point) before any trades are actually place. This is helpful because it allows you to determine your parameters before you are emotionally invested (and potentially irrational) if prices start to work against you. The most basic approach to placing stops is the “Hard Stop,” for which the trader set an exact price level, and then exit the trade is markets reach that region.
The main idea here is that your trading strategy suggests there is little reason to believe prices will rise (for short trades) or fall (for long trades) to this area before your profit target is reached. Then, if it does turn out that prices hit the stop loss, either a major change is present in the market or your initial analysis was simply wrong. In both cases, it will be wise to close your trade at a loss and look for new opportunities.
There are many ways to determine how to place a Hard Stop. One method is to use the Average True Range (ATR), which calculates the average of past highs and lows to determine a projected range for your chosen time period. Assets with high volatility have a wider ATR, while assets with low volatility will have a smaller ATR. Since it is unlikely prices will travel outside this projected range, stop losses can be placed above the projected high (in short positions) or below the projected low (in long positions).
Trailing Stops
A more active approach is to use trailing stops. Here, traders will move the stop loss higher (for long positions) when prices move in a favorable direction. In short positions, stops would be moved lower once the trade turns profitable. For this reason, Trailing Stops are also called profit stops but this approach requires continuous monitoring of your position.
This approach can be conducted manually or automatically. Most trading stations will allow traders to automatically trail the stops. So, for example, if we start with a stop loss that is 50 points away from the price, we can set a 25 point stop loss interval, which will move the stop loss higher every time the market moves 25 points in our favor.
(Chart Example 1)
Manual stops require more analysis but can be better tailored to specific market conditions. In the first charted example, assume we take a long entry in the at the black line, with a stop loss below the most recent support (the first red line). As prices move higher, we continually move the stop loss higher (each successive red line). Prices reach a top, reverse and hit the profit stop slightly below. In this example, the trader would need to actively monitor price activity and move the stop loss higher as the trade works into profitability.
Parabolic SAR
A variation on the trailing stop can be found with the Parabolic SAR approach. This indicator works well when prices move quickly in the direction of your trade, and will quickly spot out a trade when prices reverse. On the negative side, since the Parabolic SAR reacts so quickly to price trend changes, there will be many instances where you are stopped out of a postion before the full trend has run its course. The second charted example shows how a trader could exit a position using the Parabolic SAR tool.
(Chart Example 2)
In the example short trade, the Parabolic SAR is above prices, indicating a bearish bias for the trade. Once this scenario changes, it is time to exit the position as market conditions are reversing.
Donchian Channels
Other methods to set stop loss levels can be seen with Donchian Channels and Pivot Points. Donchian Channels will give traders a price action envelope that can be used to determine bullish or bearish bias in a currency. The next charted example shows traders in long positions can set stop losses using this tool. Essentially, upward breaks of the upper band signal a bullish bias, while downside breaks of the lower channel signal a bearish bias. In this example, the long trade is initiated when prices break the upper band, stops will then be placed below the lower band.
Conclusion
The placing of stop losses is critical for traders looking to maintain positions until trends have run their course, while at the same time protecting a trading account against adverse market volatility. There are many different ways traders can set their stop loss levels but it must be remembered that no trade should be executed without an exit point in mind. The wide variety of stop loss approaches might seem daunting, as it makes it difficult which method to use regularly. But this should, in fact, be viewed as a positive, as it means there are many different methods that can be used for different types of trading environments.
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