Just a quick note on stop loss placement. I speak with a lot of forex traders on a daily basis, and many of these traders often ask me where they should place their stop losses. In other words, they wish to know how many pips away from their trade entry the stop loss should generally go. In asking this question, most of these traders are searching for a rule-of-thumb that can be used under all circumstances. They are looking for a pat answer like “20″ or “30″ or “50,” that represents how much they should be willing to lose on any given trade. This is what’s known as an arbitrary stop loss. When one simply chooses a number that seems reasonable from a risk tolerance perspective, the basis for that number is essentially random. It is not customized or connected in anyway to the trade at hand. In my opinion, this is not the right way to place stop losses.
Much more sensible and effective than an arbitrary stop loss is a logically-placed stop loss. A logical stop loss is placed according to the specific price action on a position. For example, if a trader wishes to trade a breakout above a resistance level, the stop loss would logically be placed a certain distance under that resistance level. If price breaks out above resistance and then turns and heads back below the line, it is probably a false break that invalidates the reasons for getting into the trade in the first place. Therefore, the stop loss placement is logical. Likewise, if a trader enters into a trade on a bounce off a trendline, the logical stop loss would be placed a certain distance under the trendline. If price reaches that level below the trendline, it is probably a trendline break as opposed to a bounce, and the reasons for getting into that trade will have been invalidated. So this stop loss placement is also logical.
Logical stop losses almost always make more sense than arbitrary stop losses. The only primary reason for a trader to set arbitrary stop losses might be to control risk more consistently with stop losses that are always of a pre-determined size. In this instance, however, perhaps a better way to control risk is actually to plan the trade ahead of time by setting a logical stop loss AND THEN setting the unit size of the trade according to where the stop loss is placed (in view of the acceptable risk parameters).
- James
James Chen is the Chief Technical Analyst at FX Solutions, a leading Forex broker. He is also a registered Commodity Trading Advisor (CTA) and a Chartered Market Technician (CMT) Level 3 candidate. At FX Solutions, Mr. Chen writes daily currency analysis, conducts forex trading seminars, and has authored numerous articles on currency trading and technical analysis for major financial publications. His upcoming book, Essentials of Foreign Exchange Trading
(John Wiley & Sons), will be released in early 2009.
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