Managing and preserving your trading capital should be your most important job as a trader.
If you lose all of your trading capital, there is no way you can make back the lost amount, you’re out of the trading game.
If you make pips, you have to be able to keep those pips and not give them back to the market.
But let’s face it. The market will always do what it wants to do, and move the way it wants to move.
Every day is a new challenge, and almost anything from global politics, and major economic events, to central bank rumors can turn currency prices one way or another faster than you can snap your fingers.
Being in a losing position is inevitable, but we can control what we do when we’re caught in that situation.
You can either cut your loss quickly or you can ride it in hopes of the market moving back in your favor.
Of course, that one time it doesn’t turn your way could blow out your account and end your budding trading career in a flash.
The saying, “Live to trade another day!” should be the motto of every trader on Newbie Island because the longer you can survive, the more you can learn, gain experience, and increase your chances of success.
Having a predetermined point of exiting a losing trade not only provides the benefit of cutting losses so that you may move on to new opportunities, but it also eliminates the anxiety caused by being in a losing trade without a plan.
Less stress is good, right?
Of course, it is, so let’s move on to different ways to cut ’em losses quickly!
Now before we get into stop loss techniques, we have to go through the first rule of setting stops.
Your stop loss point should be the “invalidation point” of your trading idea.
Why Use a Stop Loss?
The main purpose of a stop loss is to ensure that losses won’t grow too BIG.
While this might sound obvious, there is a little more to this than you might assume.
For each trade, the trading strategy only has two possible outcomes:
- A profit.
- A loss.
This means that the strategy exits a trade when the stop loss (SL) is hit OR when the Take Profit (PT) is hit.
How To Set A Stop Loss Based on a Percentage of Your Account
The percentage-based stop uses a predetermined portion of the trader’s account.
For example, “2% of the account” is what a trader is willing to risk on a trade.
The percentage risk can vary from trader to trader. More aggressive ones risk up to 10% of their account while less aggressive ones usually have less than 1% risk per trade.
Once the percentage risk is determined, the forex trader uses his position size to compute how far he should set his stop away from his entry.
☝️You should always set your stop according to the market environment or your system rules, NOT how much you want to lose.
We bet you’re thinking right now, “Huh? That doesn’t make any sense. I thought you said that we need to manage risk.”
We agree that this sounds confusing, but let us explain with an example.
You have a mini account with $500 and the minimum size you can trade is 10k units. You decide to trade GBP/USD, as he sees that resistance at 1.5620 has been holding.
As per his risk management rules, you will risk no more than 2% of your account per trade.
At 10k units of GBP/USD, each pip is worth $1 and 2% of your account is $10.
☝️But GBP/USD moves over 100 pips a day! You could easily get stopped at the smallest move of GBP/USD.
Because of the position limits your account is set to, you are basing your stop solely on how much you want to lose instead of the given market conditions of GBP/USD.
How To Set A Stop Loss Based On Support And Resistance From Charts
A more sensible way to determine stops would be to base it on what the charts are saying.
Since we’re trading the markets, we might as well base our stops on what the markets are showing us… That makes sense, right?
One of the things that we can observe in price action is that there are times when prices can’t seem to push or break beyond certain levels.
Often times, when these areas of support or resistance are retested, they could potentially hold the market from pushing through once again.
Setting stops beyond these levels of support and resistance makes sense, because if the market does trade beyond these areas, then it is reasonable to think that a break of that area will bring in more traders to play the break and further push your position against you.
Or, if these levels DO break, then there may be forces that you are unaware of suddenly pushing the market one way or another.
Let’s take a quick look at a way to set your stops based on support and resistance☝️
On the chart above, we can see that the pair is now trading above the falling trend line.
You decide that this is a great breakout trade setup and you decide to go long.
But before you enter your trade, ask yourself the following questions:
- Where could you possibly set your stop?
- What conditions would tell you when your original trade idea is invalidated?
In this case, it makes the most sense to set your stops below the trend lines and support areas.
If the market moves into these areas, that means the trend lines drew no support from buyers and now sellers are in control.
Your trade idea was invalidated and it’s time for you to suck it up, exit the trade, and accept the loss.