Setting Solid Stop-Losses in Every Trade

06/05/2014 9:00 am EST

Focus: FOREX

Casey Stubbs

Founder, Winners Edge Trading

An integral part of being a successful forex trader is the ability to abide by a strategy and implement trading plans that support it, and an established stop-loss is essential for making that work for you, says Casey Stubbs of WinnersEdgeTrading.com.

The management of your stop-losses is basic training for a new forex trader who desires to become a successful one. This is the order that you place that will close out your trading position once it reaches the maximum amount of money, or pips, you are willing to lose. Your personal trading strategy and plan for that trade should dictate when you pull out in order to minimize your losses and maximize your gains.

What is so Important About the Stop?
Every trade comes with a certain amount of risk and since there is no clear way of knowing future prices, despite the amount of information available, you need to have a clear-cut limit on how much you are willing to lose. Traders make good deals most of the time, where they make mistakes is with their loss management. If you are losing more than half of what you are gaining, then you are going to deplete your account before you ever see any real gains.

For a trader who is not assessing the risk properly and setting the correct stop loss, they may need to make winning trades at least 70% of the time just to break even. In order to avoid those terrible odds, I always make sure my profit target is at the least an equal distance as my stop-loss. For example, if I open with a 100-pip stop I make sure to balance it with at least a 100 pip profit target. This keeps my odds at an even 50/50. This is just in theory; the reality is a trader is right more often than wrong, making the actual odds even better.

Why Not Play it By Ear?
Winging your stop-loss is never a good idea, no matter how much you are watching your trade. Humans are naturally competitive and have the tendency to stay in longer, hoping to recoup their loss rather than bow out gracefully and admit defeat. This will inevitably lead the trader to losing even more money than if they had followed their plan and heeded the stop-loss that was set.

Choosing a Stop-Loss Strategy
Knowing how you are going to set your stop-loss is a crucial part of your trading strategy. Not all methods are created equal and it may take a number of misses before you find the method that works best for you. The key is to try it out for a number of trades before dismissing it. You should also be taking good notes in your journal. You will want a running track of how you traded and why you came to each decision in order to ensure continued success.

NEXT PAGE: Methods for Stop-Loss Plan

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There are a number of methods that can be used to set your stop-loss plan:

Static Stops: This is the most basic stop-loss system a trader can use. You decide in pips where you want to pull out of the trade both in the event of a loss or gain. Once the trade begins, you do not make any adjustments but rather wait until it plays out. This is an important part of making money in the forex market. If you do not have the patience to allow the parameters you set to be met, you will not be able to earn a substantial profit.

Using static stops allows you to easily elevate your risk to reward ratio. Remember, traders are right more than they are wrong. If you have four trades running, each set with a static loss of 50 pips, and a static gain of 100 you are taking advantage of your odds. This will allow you to show a profit after each round.

Static Stops Based on Indicators: As your experience grows you can begin to use market indicators to set your static stops. Pivot points, price swings, and average true range can all help you make an informed decision about how you set your stop-loss. For example, when the forex market is volatile, a stop-loss of 50 pips is perceived as a small move. Using indicators to determine a static stop is a more sophisticated tool for the trader to use.

Trailing Stops: This method allows you to adjust your stop-loss if your trade is going well so that if it changes direction you will break even instead of suffering a loss. If you are able to move your stop-loss to the initial entry price than you have completely eliminated the risk and can now allow the trade to ride while you place your risk somewhere else in the market.

There are three ways to take advantage of the trailing stop approach:

Dynamic Trailing Stop: This is the easiest way to start out when you are experimenting with the trailing stop-loss method. Your stop-loss is set to move forward with every pip it moves towards your goal.

Fixed Trailing Stop: With this method the trader selects an increment, say 5, that the trade must move forward in order for the stop-loss to adjust at the same pace.

Manual Trailing Stops: For an inexperienced trader, this method poses the most risk and should be avoided. For it to work you must move the stop-loss yourself as the values change. This is a method that I personally shy away from as there are too many variables. Plus the risk of getting sucked into making emotional decisions runs too high. I always find it best to choose a method that allows the trade to ride with as little input from the trader as possible.

An integral part of being a successful forex trader is the ability to abide by a strategy and implement trading plans that support it. An established stop-loss is essential for making that work for you. Once you learn how to balance your stop-loss with a profit target that results in only wins or break evens you then you have mastered the art of knowing how to sit back and let your money work for you.

By Casey Stubbs, Founder, WinnersEdgeTrading.com

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