The Right Way to Place Your Stops

12/10/2009 12:01 am EST

Focus: STRATEGIES

Stops are a crucial tool in trading. They allow us to control the amount we risk on a given trade and often prevent a loss from spiraling out of control. In fact, I can't imagine placing a trade without a stop—that is how important they are. Keep in mind we are talking about directional trading like we do. There are other ways the markets can be used where stops wouldn't make sense. However, if you are simply speculating where the market will go next, stops are essential.

Occasionally, there are some traders (who usually have very little experience) who are against using stop orders. There are various excuses these traders use, but there is really one driving force behind a trader's reluctance to use stops. That reason is that these traders do not want to admit the possibility of being wrong. By placing a stop order when you enter the market, you are admitting there is a chance you could be wrong. Of course, traders are wrong all the time. No one wins all of their trades, and that is an impossible goal. However, inexperienced traders often do not place stops because they feel more comfortable not admitting they could be wrong. Of course, this changes quickly after they absorb a few devastating losses.

There should always be a reason for the placement of a stop. That may sound simple, but sometimes traders place their stop at X pips regardless of what the situation is. This makes no sense. Each pair is different, each setup is different, so each stop distance should be different. There are a number of tools traders use to determine stops such as previous highs/lows, round numbers, average true range, pivots, Fibonacci, etc.

Additionally, I generally do not believe in trailing stops. They lead to more whipsaws then are necessary and add numerous variables that make it almost impossible to significantly test the effectiveness of your stop placement. Also, I think that stops should actually be placed in the market. Unless you have brokers working for you, using "mental stops" is risky. You could be away from your computer when the price breaks through your stop level. Even worse, you may wait for the pair to rebound from your stop and it could go further against you. Placing the stop order in the market is the way to go. Also, never change your stop once you enter the trade. Before the trade is entered, you are able to be much more objective about the market. Once you are in the trade, your emotions take over and you are far more prone to mistakes. Moving a stop further from your entry once the trade has begun is also a mistake that should never be made.

When I place my stops, I primarily utilize Fibonacci levels. Some additional tools I consider (depending on the trade) are significant highs/lows, round numbers, and trend lines. Because of the number of tools, there is some subjectivity involved, but not much. For our purposes in explaining stops, we will assume we are going long (buying) in this hypothetical situation. We would obviously reverse this process for any short (selling) trades. Also keep in mind that this method of determining stops is specifically meant for the geometric pattern recognition methodology I use on fx360.com

First, we have to determine where we will enter the trade. When I determine the entry, it is typically at a strong level of support (remember, this example assumes we are going long or buying). This entry is usually determined by a combination of two or more Fibonacci levels and harmonics (AB=CD, for example). I then typically put my stop above the next lowest line of support. This may sound odd to some people because it initially seems more logical to put your stop exactly at the next level of support or below the level of support.

However, this method of stop entry has worked best over many trades based on my experience. Placing the stop at the next lowest level of support is illogical. Why would you want to be stopped out at a possible point when the pair could reverse in your favor? That is the worst spot to place a stop, in my opinion. Many traders who use this methodology place their stops below (or beyond) the next level of support. However, this makes the risk/reward ratio of the trade far less favorable. Also, the pair could hit that level, shoot a little past, and still be stopped out even if it ultimately brings the price back up. Next, even if the pair reacts off of the next support level, this moves the profit target much lower. This hurts the risk/reward ratio further. Finally, in my opinion, the trade has failed if we hit that next level and we are "wrong."

Placing the stop just above the next level of support below the entry allows room for the trade to work while maintaining a favorable risk/reward ratio. I also try to incorporate the other factors we already listed above (significant highs/lows, round numbers, and trend lines). Therefore, sometimes we move the stop slightly up or down based on these levels. Setting stops is not always easy, and it is also the most subjective aspect of our methodology. Hopefully this sheds some light on what I look for when placing stops.

By Bradley W. Gareiss of GFTForex.com

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