Learn to use Stop Loss effectively

Still unsure whether you need it?

Every day hundreds of Forex traders blame themselves for being so naive and trading without protective stops. Hundreds of others lose funds worth weeks, months & even years of trading just only in one very unsuccessful trade.

And yet another hundreds of traders, having heard dozens of times about importance of protective stops, open new trades ignoring the well known money management rules.

Stop loss isn't often a favorite tool for many Forex traders as it requires taking necessary losses, calculate risks and foresee price reversals. However, a Stop loss tool in hands of a knowledgeable trader becomes rather a powerful trading weapon than a cause of disappointment and painful losses.

Every trader is free to develop his / her own trading style and implement own money management rules. We will go over several methods of using Stop losses.

1. Simple equity Stop

It's an important money management rule: not to risk more than 2-3% of the total account per trade. According to this rule, a trader would place an order and based on a lot size would calculate amount of pips required to reach the limit of 2-3% of the total account balance (and a stop loss will be placed at that point).

For example: a trader has $1000 USD account, he places a buy order of 4000 units on EUR/USD, which will give him on average $0.40 cents per 1 pip. Since 2% risk that he is willing take equals $20 USD ($1000 * 2%), calculations will be next: $20 / $0.40 cents = 50 pips is the limit for this trade.

2. Chart based Stop

Used by many traders, this stop relies on different chart patterns, indicators and signals received when analyzing the market. There are many styles & techniques associated with different Forex trading systems. Examples of some of them can be found at TrendLine and Fibonacci.

There are several approaches to placing protective stops: 
- stops based on swings high / low, 
- stops using trend lines, 
- Fibonacci related stops, etc.

Let's take a look at some examples below:

A stop loss based on the last swing low (double-bottom pattern)

A stop loss based on Fibonacci projection

A stop loss using a trend line

Chart based stops are widely used in combination with simple equity stops.

3. Margin Stop

The method is not recommended for novice traders.
It represents a quite interesting approach that would rather suit Forex traders, who like placing all money at once on a particular trade. But at first, a trader should divide his account into several equal parts to ensure that the whole capital will not be blown away in one shot. Supposing that a trader plans to trade $10 000 USD lots, it's suggested that an account opened with a broker "weights" in between $1000 to $2000 USD.

Then a "play" with a margin starts. Depending on the leverage that is going to be used and carefully choosing a lot size, a trader can calculate the point where a margin call will occur.
This point will work as a global stop loss, which if crossed, will cause the account to be closed automatically.

A predetermined risk, no concerns about the manual stop loss, a maximum trading position size — all that creates the whole new approach to trading Forex.

4. Volatility related Stop

Price volatility can also be used when placing a Stop loss order. During active hours & high market volatility, traders should place stops further than usually to avoid seldom price noise and react only to major price changes.  During the periods of a low market volatility, protective Stops should be placed closer in order to react in time should the market accelerate.

One of the good technical tools to measure price volatility is Bollinger bands indicator.

Let's take a look at the following example:

5. Protective stops are extremely important during huge rallies

Simply because too many traders react on those "rally events", one can face a situation when it becomes impossible to access a trading platform in order to close the order or at least place a protective stop. When there is a serious shake up in the market (due to news announcements, economical, political and other events), trading servers can be quickly overloaded and can cause trading delays or not respond at all. In such cases Forex traders become helpless while money is draining out of their accounts. The only option here would be to call your Forex broker and make voice orders. Again, there will be no guarantee that brokers aren't overloaded with calls at this moment as well, and so trader should wait... dreaming how simple things could be if a stop loss was there.

Wish you to make wise decisions and never experience such troubles!

Sourcing:
http://www.forex-money-management.com