Setting Forex Stops with Fibs

02/26/2014 9:00 am EST

Focus: FOREX

Most traders are familiar with the use of Fibonacci ratios as entry and take profit points, but few have considered placing stops with Fibs, notes the staff at DailyForex.com.

Using unconventional methods for setting stop loss levels can have a surprisingly uplifting effect on profitability, and when a method can be found that is both unconventional and reliable, a serious edge can be uncovered. Placing stops with Fibs can be such a method.

The point of a stop loss is to limit risk. Most traders tend to take the view that a stop loss should be placed at the point where the trade becomes “wrong”, i.e. an adverse point, which if reached, means the trade is likely to continue going in the wrong direction. Traders also tend to set stop losses very conservatively, telling themselves that the trade needs “room to breathe” as they place the stop one pip above or below the trigger candle or swing high or low. Is this the correct attitude to take? That depends very much upon the individual trader’s risk to reward profile and trading style.

The best trades often spend little time in negative territory. This is not always true, but if one looks at a large sample of historical trades produced by most types of strategies, especially breakout strategies, a positive correlation of approximately 0.25 is usually found between the trades that take off immediately and the trades that ultimately are winners. This has serious implications for the traditional approach of setting stops so that trades have room to breathe, as a disproportionate number of winning trades don’t need any room to breathe!

This means that many strategies, especially shorter-term breakout strategies, produce a higher positive expectancy if stops are placed more tightly than the other side of the candle or swing. There will be more losers, but the winners will be larger overall. How to tighten these stops? One approach is to look within a shorter time frame for obvious micro support or resistance levels. This can work extremely well, however, often such a level is not clearly identifiable, and it is not practical under seriously pressured entry conditions to spend much time looking for one. This is where Fibs can come in. Calculate the pips risk mentally from your entry to where you would traditionally place your stop, and apply that number to a Fib calculator. You can select any of the common Fib ratios as they all have some power, but the 50% level does tend to be the strongest. Placing your stop two or three pips beyond the 50% retrace level can almost double the size of your winning trades while being surprisingly protective of many of the best ones. It is recommended to review your past trades and see how your results would have been different using this type of stop loss strategy.

There is an alternative approach that can be taken in placing stops with Fibs that is especially appropriate for longer-term strategies that utilize wider, larger stop losses. We can take it for granted that there is stop loss hunting especially during periods of low liquidity. These hunts can and will take the price to those areas one pip above or beyond the swing high, where the herd tends to place its stops. Consider trying to place your stops more out of harm’s way by finding a widely used Fib retracement or extension ratio that can be applied to a larger swing that is placed not too much further away than their traditional stop loss placement area. Place your stop loss a few pips to the other side of that level and you might find better protection from the hunters, at a small extra premium. If your trade is for a large target, it can be worth it.

By the Staff at DailyForex.com

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