The Importance of Stop Losses
I often come across traders, and people sending money abroad, who have let one or several bad trades get away from them, and ruin otherwise profitable trading weeks or months. More often than not these traders didn’t place a stop loss on the trade, and the market then moved significantly against them. Closing a trade at a loss can be very psychologically challenging for many traders, many newer traders find it particularly difficult to close a losing position. Automating the exit of the position can be very important as many traders are tempted to cling onto a position in the hopes of it coming into profit. It’s not uncommon to see traders hold onto positions which can lead to draw downs of 20-30%, of course nobody likes losing money on trades. But one of the keys to successful trading is maintaining your capital, in order to take advantage of the times when your system or strategy pays off. As is commonly said cut your losses quickly and run with your profits. Having a stop order in place lowers the chance of your emotions interfering with your trading, as it takes the decision out of your hands leaving it up to your brokerage to implement the stop when it is triggered.
Stop orders will only be effective if you leave them alone. Many traders setup up Stop losses only to then go and alter them to give their trade more time to come good. Such trading can be just as dangerous as trading without stop losses at all. If you are going to the effort of setting a well thought out stop loss in the first place, why would you then decide to alter this stop loss? Such behavior is absolutely mad and can lead to a trader adopting some very bad habits.
How and Where to place Stop Losses
Stop Orders are most effective when they are placed correctly, it is not uncommon to see traders complaining that their stop losses were triggered just before the market turned in their favor. I do a lot of my trading through a MetaTrader 4 Expert Advisor program which I personally programmed and during my back-testing, I spent a considerable amount of time working where the optimum place would be to place a Stop loss. To close to the opening position and you will likely be stopped out prematurely, to far away and the trader is likely to take to many big losses.
When deciding where to place a stop loss, a trader should ask himself or herself two important questions:
- Where has the instrument traded recently?
- At what point will I know that my trade was misguided?
You should normally place Stop Orders, at the point were the market has traded recently. If an instrument breaks through a support or resistance level its usually a sign that a new trend is beginning. When a stop loss is triggered at these points it is generally a good indicator that your original trading position was misguided.
In the above example, I would have placed a Stop Loss somewhere between the two red lines on the image, depending on how much risk I was personally willing to take on I may have even placed a Stop Loss a few pips below the bottom red line. If the instrument was to break through the bottom red line it would certainly indicate that a new trend had formed and that a Buy position was misguided. While I would have taken a considerable loss, I would have prevented myself from being trapped in a position which could potentially seriously damage the health of my account. I could walk away and come back to trade another day. If an instrument breaks through a resistance or support level against you, it should be taken as a clear sign that your initial trading idea was mistaken, there are a number of ways to plot support and resistance levels.
Stops are one of the most important ways in which a trader can manage risk and traders who are not using Stop Losses, should begin to start using stop losses.