How to Avoid Setting Your Stops Too Tight

08/25/2014 9:00 am EST

Focus: FOREX

John Forman

Senior Forex Analyst, Thomson Reuters IFR Markets

Proper stop placement will help you avoid a trading trap that many forex traders find themselves in, but sometimes you can overdo it, so John Forman of The Essentials of Trading shares how you can do it right.

I've written before on how tight stops make me nervous because too often those who employ tight stops are thinking about how many points or pips they are willing to risk on a given trade, having already decided how big a position they are going to trade ("I'm trading a standard lot of EUR/USD, and I only want to risk $200, so my stop is 20 pips"). Sound familiar?

This also ties into the whole fixation on risk/reward ratios I discussed in Stop Getting Hung Up On Stops, Targets, and Risk/Reward. Too many traders fail to realize that the closer they put their stop, the higher the probability that stop gets hit. The result is normal market moves take them out of their trades, which leads some to claim stop-hunting to place blame elsewhere. It also means a lower win %, which can severely impact their overall profitability.

What these traders should be thinking about instead is how many pips of risk there is in the trade they are looking to make, and then backing out the position size ("I'm risking 50 pips, so in order to only risk $200 I can put on 4 mini lots of EUR/USD"). Many traders figure out their risk point using some form of technical analysis, identifying a point beyond which the market should not go if the trade is to retain a good prospect of working out as expected.

There's something else, which can help in this regard, particularly for those whose trading approach does not lend itself to easy identification of exit points-or for those working on trading system development. It's the concept of value-at-risk (VaR). The basic idea of VaR is that you develop an idea of what kind of move the market may make against you based on historical information. There are limitations to VaR, which I will address below, but it can be a starting point for developing a strategy for stop placement.

The forex broker OANDA has a VaR tool, which can be used to this purpose in terms of currency pairs (I don't know off-hand of a similar one for other markets, but if you do please post a link in the comment section of my Web site below). It looks at recent history to give you an idea of the size of moves have occurred as a certain significance level. For example, if I want to look at EUR/USD in the 30-minute time frame covering 10 bars (5 hours) I get the following:

chart
Click to Enlarge

NEXT PAGE: Using VaR Can Help Determine Proper Stops

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Here we have a breakdown of how EUR/USD has traded over the last 300 periods. It tells us that 95% of the time the market moved 90 pips or less, averaging 39 pips, with a maximum move of 127 pips. The report also provides a graphical representation of the types of moves the market has made. Reports like this can be very useful in understanding how far away you should put your stop to avoid it getting hit by normal market volatility.



chart
Click to Enlarge

In the example above, if you were to have your stop only 20 pips away from the market, the odds would strongly favor it being hit, but if your stop was at 50 pips, the odds would favor it not being reached.

I'm not suggesting you just use VaR in this fashion by itself to set your stops, but you can certainly use it to get an idea of whether a stop you are contemplating is in a high-risk position or not.

A word of caution with this kind of backward-looking VaR. The future may not look like the past. Specifically, the market may be more or less volatile (more being the bigger risk for most traders). As a result, you would be well-served in joining some kind of forward-looking indication of volatility to a VaR analysis so you don't get caught by a major shift.

Also, don't let the 95% or 99% confidence level stuff lull you into not taking proper risk precautions. A number of financial institutions were basically sunk during the financial crisis by developments beyond those confidence levels. That's where individual traders can get destroyed too. And you don't need to trade all that much before you effectively assure that you're going to have to survive a market move beyond those bounds.

By John Forman, Author, The Essentials of Trading

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