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Stop Placement

The information, including Commentary and Trade Ideas, provided on FX360.com should not be relied upon as a substitute for extensive independent research which should be performed before making your investment decisions. Global Forex Trading and FX360 .com is merely providing this information for your general information. The information and opinions presented do not take into account any particular individual’s investment objectives, financial situation, or needs. All investors should obtain advice based on their unique situation before making any investment decision and should tailor the trade size and leverage of their trading to their personal risk appetite. Any projections or views of the market provided by FX360.com may not prove to be accurate.

Last updated 9/25/2009 7:23 PM EST (GMT -5) 15 Comments

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Bradley W. Gareiss

Technical Analyst, GFT

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) that 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 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 patter 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 2 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 bring 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.

The information, including Commentary and Trade Ideas, provided on FX360.com should not be relied upon as a substitute for extensive independent research which should be performed before making your investment decisions. Global Forex Trading and FX360 .com is merely providing this information for your general information. The information and opinions presented do not take into account any particular individual’s investment objectives, financial situation, or needs. All investors should obtain advice based on their unique situation before making any investment decision and should tailor the trade size and leverage of their trading to their personal risk appetite. Any projections or views of the market provided by FX360.com may not prove to be accurate.

The views of the authors and analysts are not necessarily those of Global Forex Trading, its owners, officers, agents or other employees. FX360.com and the currency research team will not be responsible for any losses incurred on investments made by readers and clients as a result of any information contained on FX360.com. Global Forex Trading and the currency research team do not render investment, legal, accounting, tax, or other professional advice. If investment, legal, tax, or other expert assistance is required, the services of a competent professional should be sought.

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Comments (15)

mikelawlor

September 25, 2009 at 07:51 PM ET

Another compellling reason for the use of stops is to protect your account if you are in a trade and something mechanical happens like the loss of power, phone line interruption or computer crash.

ml

bgareiss

September 28, 2009 at 03:19 PM ET

True, that would be a worst case scenario reason. If you internet, land line phone, and cell all go down, it is not your day. Brad

Markin

September 25, 2009 at 08:51 PM ET

Dear Bradley,

Great artcle, now I have a better understanding of stops.

bgareiss

September 28, 2009 at 03:18 PM ET

I'm glad this helped. Brad

BUFFALO DC

September 26, 2009 at 03:27 PM ET

Yes, Stop placement is so important. You MUST figure out how much to risk, no more, and be willing to stick with it even if you lose. And mikelawlor makes an excellent point. MOST people never have to worry about mechanical failure, but it DID happen to me! Its a sad story really, not for the faint of heart, LOL!

A few years back Time Warner cable took over for Adelphia up here in Buffalo. The first month or so I had ENDLESS problems with my internet, but ever time I called them to troubleshoot, and I called EVERYDAY for a month, they would run ping tests and such and nothing ever came back wrong on thier end. Sooooo....

Its was a thursday night, the night before the Non-Farm Payroll numbers came out. I had 2 open Long EUR/USD trades that were in the profit. I went to bed early, figured I would get up early friday, about 4am(EST). I would take profit on those postion if they were in the green, or maybe even take a small loss if they were not too far in the red, then get ready for the ACTION.

When I woke up friday my monitor only showed my desktop, my trade platform had shut down. When I looked at my modem, only the power light was lit. It was searching for a signal. I called TW and they could FINALLY see i was having a problem. They said a tech would come to the house between 10am ad Noon!!!!

When the NFP number came out it was dollar positive! My gut sank! I even called my brokerage and they said they could not close the trades, only the account holder can do that, online! Nothing they could do! I have a desktop, no wi-fi, no laptop to run up to a wi-fi spot and take care of it. The only friend I have in the neighborhood with a computer didnt have it, his girlfriend left him and took it with her! And the only person I would trust to give my unsername and password to so he could close the trade for me was in Thailand, and the only way I could get ahold of him was on the MSN Messanger!!

Murphy's law, I guess....

So when the tech came to my house around 11am she said the problem was my cable line in the room had a splitter, off of that 1 line to the cable box, the other line to the modem and that just wouldnt work. She installed a second line, a dedicated line to the modem and ever since, no problems. However.....

The EUR/USD tanked hard. No stop loss in place and I was down more that 60%!! I was only about 40 pips away from the margin call so I held trades over the weekend and monday they dropped to hit the stop loss!

Are you ready for this????

I went from $40,000 to just under $10,000! I was so shell shocked I couldnt make a trade for over 2 months! I was petrified it would happen again!

Here's the funny part. I checked after that fact, and when I woke up that friday my 2 trades were in the profit, so I would have closed them with profit in hand. When the NFP number came out better that expected I would have shorted the EUR/USD and if I held the trades for that same amount of time I could have turned $40,000 into over $65,000 by the next monday!

Since then I have completely changed the way I trade. I only put 10% of my money on any trade, and I only risk 10% of my overall cash. So when I open an order ticket my order size is already set, and the stop loss is already set(at 10%). If I had done it like this back then I would have lost no more than $4,000, with $36,000 left.

We all live and learn, I guess. Sometimes the lesson's we learn, we learn the hard way.....

DC

bgareiss

September 28, 2009 at 03:18 PM ET

This is a good example of why I feel stops should be used on every trade. It also is a good example of why you should make sure you have the authority to close trades over the phone. Brad

apollo

September 27, 2009 at 03:10 AM ET

Hello,

Please, explain this sentence

" if the pattern comes within 10 pips of hitting the entry, does not enter, and reaches T1, the trade is also invalidated."

Thanks in advance

bgareiss

September 28, 2009 at 03:15 PM ET

If the trade almost enters (in this case, comes within 10 pips of entry), but does not enter and hits our first profit target, then the trade may have "worked" already. Therefore our edge is gone and we will not take to the trade. Brad

AndrewB

September 27, 2009 at 05:00 PM ET

Also, Brad, in reference to your NZD/USD trade, you stated:

"If there is a gap of more than 10 pips up that is not "covered" before hitting the entry, I would hesitate taking this trade."

What do you mean by that?

Thanks.

Andrew

bgareiss

September 28, 2009 at 03:17 PM ET

In forex, the markets can gap over the weekends. If a market gaps, it signals possible strong momentum in the direction of the gap. "Covered" means that if the market gapped up, the pair dropped back down below the close on Friday, thus "covering" the gap. Brad

AndrewB

September 28, 2009 at 07:43 PM ET

Thanks!

pipsqueak

September 28, 2009 at 08:31 PM ET

BUFFALO DC, risking 10% of your capital on one trade is not trading at all, it's gambling. Good risk management strategies seldom exceed 1% (or perhaps 2% if you are a very experienced trader).

bgareiss

September 28, 2009 at 09:33 PM ET

I agree that 10% is a lot to risk on each trade, by the way. 1-3% is the range most experienced traders use. Brad

phi

September 29, 2009 at 12:21 PM ET

Bradley,

Thanks for the great article on stop placement. I have a question about entries. Your entries are very precise. For example, in the recent CAD/CHF trade your entry was at 0.9381. How did you determine this number? I mean why didn’t you choose 0.9380 or 0.9382?

Thanks

bgareiss

September 29, 2009 at 02:10 PM ET

It varies from trade to trad because the three main points of support/resistance never line up exactly the same. The three ratios are the retracement/extension of XA, extension of BC, and AB=CD. On the CAD/CHF trade, I added the spread to the AB=CD level (0.9374), so the entry wound up being 0.9381. That entry also was at the 161.8% of BC, but a little below 161.8% of XA. I guess if I had to make a general rule I follow, I usually put the entry at the middle level of the three main levels. Of course, that can change based on the situation, but that would apply to most trade setups. Brad

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