What you need to know about Stop Loss

Hello, fellow forex traders!

In this lesson, we will talk about Stop Loss (SL). Stop Loss is a very important thing that your success or failure in trading depends on. Next, we will learn what a stop loss is, where to set it and in what way, which SL is better to use, we will compare short and long stop orders, and finally, we will come to the conclusion whether it is possible to trade without a stop loss and how wise decision that is.

What is a Stop Loss?

Stop Loss is an order limiting your losses, automatically closing your position when you reach a certain price level. Suppose you looked at the candle and decided that its typically long shadow most likely indicates the impending reversal. Thus, after closing the candle, you open a sell order.

But, after a while the price goes up, that is, your assumption was wrong and the price goes against your position. Of course, you can close the position at any time by hand, thereby fixing the loss, but, for example, if you are not near your computer at the moment, or some emotional factor may work, a naive belief that the price will definitely reverse. Subsequently, losses can lead up to the complete depletion of your account. That is, theoretically, if you do not have a stop loss, then the risk of the deal will be equal to the deposit.

In the event that we pre-set the stop loss at a certain level, we thereby limit the potential risk in advance, knowing that in this particular transaction we will not be able to lose more than a certain amount, or, more competently, a certain percentage of the deposit.

Stop loss must be set in the place where it becomes clear that we were wrong. That is, where the setup loses its meaning. In this case, it is obvious that our assumption will lose its force if the price goes beyond the extreme point of the tail. Accordingly, we put the stop loss a little above the maximum of the candle. In case of any technical emissions, we always add a couple of points.

How to set a stop loss in MT4 / MT5

The standard order window is almost the same in the MetaTrader 4 and MetaTrader 5 terminals. In addition to the buy/sell buttons, there are fields for setting take profit and stop loss. Here you can choose a stop loss before the opening of the deal, which is recommended if the market is fairly calm. In the case of a sell, the stop is placed above the opening price, in the case of a buy, below.

If we open the position, the stop loss will be displayed on the chart as a dot-dash line, and also in the terminal window in the “S / L” column. To edit an order, double-click on the appropriate line in the terminal.

Here you can change the stop loss to either side. If you opened a trade without a stop loss, then you can add it to the position. It is worth noting that on some types of accounts, it is impossible to put a stop loss simultaneously with the opening of a deal, and you can do this only after opening a position.

Ways to set a stop loss

Local extremum. Suppose, in this case, we decided that the trend would continue and opened a buy order at the current price. One of the banalest, classic methods of stop loss setting is putting it below (in case of purchases), or above (in case of sales) of the previous extremum.

Note that we never set a stop loss exactly at the price high or low. It should be borne in mind that small price splashes are always possible, and not to let the stop loss be knocked out, we always put the stop loss just above or just below the benchmark (extremum).

Big candle. The next way to set the stop loss is at the extreme point or above the extreme point of the big candle. Under the definition of a big candle is a candle that is three times bigger than the average candle on a visible chart.

Let’s say you saw such a big candle and decided that it was a signal to buy. In the case of a purchase, a stop loss can be placed under its extreme point a few points below the minimum.

Trend line. Also, the stop loss can be set under (in the case of purchases) or above (for sales) the trend line. We have a separate lesson on how to build a trend line. A logical question, since the price and, accordingly, the trend line will change over time, is it worth moving the stop loss? In this case, the stop loss can be moved along the trend line, for example, with each new candle.

Moving Average. Another method is to set the stop loss on the moving average. In general, there is something in common with the trend line installation method. This stop can also be moved after the average.

By time. Stop loss can be installed not only by price but also by time. At the opening of the transaction, we set the stop loss at a sufficiently large distance, in case of force majeure. But, in fact, we leave the deal after a certain period of time, if there was no movement in the direction of profit. A well-known strategy is the filter of 5 candles. That is, on the basis of any signal, we open the position, and if within 5 candles the price stays in the same place, which means the signal has not had any impact on the market, then we just exit the transaction.

Key levels. A reliable way to set a stop loss is at the nearest support/resistance level. In the case of sales, we put the stop just above the resistance level, in case of purchases - just below the support level.

Volatility. A good guide for setting a stop loss is volatility. This method of stop loss is suitable for intraday trading. Data on volatility can be viewed here. In the list, find the desired pair and see the average daily volatility.

For example, for GBPUSD this value is just under 100 points.

Further, we subtract from this value the distance that the price has already passed during the day. In this case, the price has already gone 60 points up. Hence, theoretically, the price can either go up by another 40 points or go 100 points down. Stop loss is set according to these values.

In general, this method is very subjective and is more suitable for determining where the price can go, that is, how much the price can still squeeze out of the market. But, for example, if the price has already passed 120 points, you can set a very small stop loss around 10-20 points with the expectation that the average daily volatility of the pair has already been exhausted and the probability of further price movements in the same direction is small.

Parabolic SAR. Another classic method for calculating the stop loss is using the Parabolic SAR indicator. Everything is simple. When opening a trade, set the stop loss at some distance behind the Parabolic points.

ATR Indicator. The method I highly recommend is the stop loss setting for the Average True Range indicator (or ATR). ATR is an indicator of market volatility. As a tool for installing stop loss, it is very, very good. Indicator’s measurements change along with market volatility and, accordingly, we always have a stop loss corresponding to the current volatility of the market.

To set the stop loss, look at the current ATR value. In this case, 12 points are the lowest possible stop loss for a given instrument and timeframe. Typically, the ATR readings are multiplied by a factor, usually from 2 to 4. It depends on your strategy, your sensitivity to risk and the views of the market.

It is best to use a combined option. That is, as an indicator we take ATR readings and when setting the stop, we adjust it relative to the nearest extremum or support/resistance level.

A short stop loss or a long one?

Here, again, there are different opinions. You are free to choose your option, which is more to your liking - more short stops or fewer, but longer ones. Here, it depends on the particular trader.

Can I trade without a stop loss?

Theoretically, it is possible, of course, but this imposes both trading and emotional risks. There are experienced traders who successfully trade without a stop loss, but they already have vast experience behind them. If you are an inexperienced trader, trading on the market for less than a year - then always use a stop loss.

Also, the correctly calculated Stop Loss can be moved with the price. However, never move the stop loss against the price. That is, the price goes against you, and you are trying to move the stop loss away – don’t do that, because there are certain price levels to which the price does not return for a very long period of time.

Conclusion

That’s all, friends. Be sure to check the ATR indicator if you are not yet familiar with it. Remember, technical analysis is not an exact science, but an art. Apply combined techniques and do not forget to use a stop loss.

Regards, Michael

ForexTraderPortal.com