Although stop loss orders may be a topic that most trading blogs will prefer to avoid writing about (as it relates to losses and not to glamorous wins), for me, placing a proper stop loss order is the difference maker between ending up with a profitable trade and between watching a profitable trade working as planned without you in it.
Most newbies and novice traders are setting their stop loss orders based on the Dollar Value of their acceptable risk. That is actually a common mistake that you should avoid and instead, as I will demonstrate with real trading example from last week, your stop loss order placement should be based purely on technical analysis.
These days, with illiquid markets and the spread of algo trading, false breakouts and stop loss hunting are becoming more and more frequent . That makes the topic of setting a proper stop loss even more critical and even more crucial to understand and master. That is why I decided to dedicate this week’s Weekly Markets Analysis newsletters to this subject.
What is a stop loss?
As defined by Investopedia.com, a stop loss order is an order that is placed with a broker to sell (or buy in case of a short trade) a security once it reaches a certain price that reflects the max risk you are willing to take on a trade.
A stop loss order is meant to take the emotions factor out your trading decisions. The stop loss should be defined before your enter the trade, when you aren’t emotionally involved with the trade, and (assuming that you are trade according to your plan) its purpose is to take you out of the trade if and when the price reaches a Price Zone that violates your initial setup. Proper stop loss will protect you when your setup fails and will prevent you from making an emotional trading decision when you are carrying a loss.
Hard Stop Loss vs. Logical Stop loss
There are many ways to implement a stop loss:
- Setting a Sell/Buy orders that will cover your position once they are touched by the price (hard stop loss).
- Setting Sell/Buy orders that will scale you out of the position as the price advances against you (also defined as hard stop loss, only gradual)
- You can also use Logical Stop Loss orders that aren’t based certain price levels and instead they are based on certain markets conditions. You do this by using Indicators such as MAs or ATR for example.
- You can also define your risk by using certain options strategies (straddles, Iron
With the increased frequency of False Breakouts and Stop Loss Hunting activities by market makers, there are some traders that prefer to work without an actual stop loss order. Instead of using a Sell/Buy orders they have a logical stop loss and alerts that are based on a longer term analysis and defined by specific markets conditions that support it (like volume, candle sizes, volatility etc.). Once those pre-defined markets conditions are no longer vaild, they manually get out of the trade – Obviously such an approach isn’t made for anyone and it is more suited to longer term
traders (swing traders and position holders) and highly experienced traders that also know how to control their emotions and cut their losses when they need to.
Pros Guidelines to setting a stop loss
Here are few Dos and Don’ts guidelines for setting a stop loss like a pro:
- DO NOT set your stop loss based on a random amount of pips! – People often “feel like” what their stop loss should be (“I feel like I should use a 25 pips stop loss… that should be enough”).
- DO NOT set your stop loss based on how much money you are willing to risk – Your position size should be determined by where the stop loss is, not the opposite.
- DO NOT move your stop loss once you’ve placed it properly
- DO NOT place your stop loss near obvious price levels (like round psychological levels for example)
- Set your stop loss based on Price Zones and conditions that confirms your analysis (see more details below)
- Adding a buffer above/below the Price Zone you decided to use can prevent being stopped out by a spike.
- Use higher time frames to find reliable Price Zones to use for your stop loss orders.
- Set your Stop Loss first and only then decide and adjust the size of your position.
- Keep a R/R ratio of at least 1:1
- Move your stop loss only once you’ve booked profits and the price generated a technical event that allows you to advance it with the direction of the trade.
Using technical elements to set a stop loss
As mentioned above, your stop loss should be based on technical analysis and not on feelings or the Dollar Value of your acceptable risk.
Here’s an example of a bullish setup I sent to the Elite Zone members not too long ago:
Yahoo ($YHOO) was trading inside what I considered a potential Bull Flag. During June 27,28 $YHOO created a minor False Break signal when it declined below its MA to test the bottom of the Bull Flag. The False Break scenario was confirmed later on that YHOO climbed back above the MA lines and created a Bullish Pinbar on July’s 9th.
The bullish scenario was that $YHOO will advance higher once it’ll break above the top of the Bull Flag and my stop loss was set below the confirmed support of the MA lines.
As you can see the setup had almost 2R (R/R ratio) and $YHOO reached just cents below my target zone last week.
In this example, the technical elements that were used to set stop loss below were the MA lines that acted as confirmed support lines.
A different trading scenario for the same setup could have been buying YHOO on the breakout with 42-43$ as potential target zone, but with wider risk (longer term analysis):
As you can see, also here the R/R is better than 1R and, in addition to the bottom of the trading range, the stop loss is also placed below the 200 days MA line that should act as very strong support line.
In this example, the technical elements that were used to set the stop loss were the bottom of the Bull Flag and the 200 days MA line.
The Buffer Zone
Here’s another example of a setup we had in the Elite Zone last week for $USDJPY:
As $USDJPY advanced higher from the Psychological Support Zone of 100 (setup I published in my Weekly Markets Analysis newsletters couple of weeks ago) it approached a Sell Zone that included the completion of an harmonic pattern (Bearish Bat), the 50 days MA line, a daily structure zone and a daily downtrend line – A very interesting potential Sell Zone that I was monitoring
to find a short term bearish entry in.
Reading the chart and the technical elements described above… and understanding that this underline has just experienced a strong rally following a massive sell off led me to use a wide Entry Zone (almost 150 pips) and therefore it required a wide risk.
The entry could have been right at the PRZ with the 50 days MA line (near 106) or near the top of the entry zone, near the trend line – 107 – That depends on your trading style.
The stop loss considerations where as follows:
- The First line of defense was the 50 days MA line. As you can see, $USDJPY did stall a little below this resistance line.
- The second defense zone was even stronger – The Harmonic s rules guide you to use a stop loss above X in case of a bearish Bat pattern like I had for $USDJPY. In
our case, the X point was right on 107 – The top of the structure zone and the meeting point with the daily downtrend line – Nice combination of several
technical elements that create a technical protection zone
Technically, a stop loss just above 1.07 could have been used with an assumption that the protection of the X point level, the structure zone, the 50 days MA line and
the downtrend line will be enough…. But, as mentioned above, based on the fact that this pair had a 600 pips rally in few days, squeezed higher in a formation
of a rising wedge and 1.07 is a round psychological level that just screams for stop loss hunting, placing a stop loss above 1.075-1.08 was a wiser thing to do.
As you can see, a wider stop loss may have reduced the R/R to 1R, but it prevented being spiked above the trend line up to 107.5 on BOJ stimulus rumors:
The additional 50 pips buffer allowed us in the Elite Zone to end the week with a profitable trade and perhaps catch a daily reversal with a daily Outside Bar.
The two examples above demonstrate how using technical elements to set a proper stop loss allow you to utilize on a successful trading plan. Using tight stop loss of 20-30 pips in $USDJPY’s bearish setup could have led to several failing attempts to short the bearish Bat for example, to multiple losses, frustration and eventually for staying out of a winning trade.
By using strong technical elements (such as the 200 days MA line in YHOO or the daily downtrend line in USDJPY) and additional safety buffer you increase the chances of your trading plan and your edge to work.
Only once you know where your stop loss should be, you can determine the size of your position – For example, for USDJPY’s bearish setup, the required risk (based on the stop loss location) was
about 150 pips. That means that if you would have wanted to risk only 100$ on this trade, you would have needed to use a position size that is less than 1 mini lot. A use of more than 1 mini lot could have either cost you more than your acceptable risk … or spike you out of the position with your max loss before the price eventually turned to be a winner.
Use the guidelines written above when you prepare your next trade. Stay discipline to your trading rules and your risk management rules. Use a proper position size and let the trading plan work. I guarantee you that your trading performance will improve in drastically