How to set a stop loss

Are you sick to death of your stop loss getting touched, only for the market to reverse back in your favour?

It’s a common gripe among traders.

Today, I want to look at what’s going wrong with your stop level … why it’s happening … and what you can do about it.

A game of hide and seek

My youngest son loves to play hide-and-seek. Before bedtime, he often badgers the rest of the family into a quick game.

And it usually is very quick – because, to be frank, he’s just not very good at hiding. He always hides in the same place (under the sofa) and giggles loudly.

If you’re wondering what this has to do with stop levels … it’s that most of us put about as much thought into our stop levels as my son does into his hiding place.

And we seem genuinely surprised that anyone is actually looking for our stops.

Have you ever accused your broker of running your stops? (I’m talking the accusing them by muttering something under your breath or swearing at your screen – not actually calling your lawyer!)

Did “they” hit your stop loss and then run the price back up?

It must have been your broker, right? Because “they” knew where you’d put your stop – so they must have done it deliberately? Right?

Well, hang on a minute.

Where did you put your stop level?

Oh, just below that area of support?

You cunning old fox you!

And you thought no one would guess it was there?

The truth is that most of us could do with being a bit smarter with our stop losses, and we may find our success rates improving dramatically.

How to set a stop loss: the basics

Before I look at how we can improve on the fundamentals of stops, let’s look at the basics we should be taking for granted …

1.
Never measure your stop distance based on your position size. By this I’m talking about the kind of thinking that says, “I’ll be trading with a stake of £4, I don’t want to risk more than £200, so I’ll need to put my stop level 50 points away.”

This is back-to-front thinking and leads to traders putting stops way to close for their style of trading. Instead of planning our trades on how much we want to make, we should plan our trades based on controlling risk.

2.
A stop loss can be about more than just the maximum risk we’re prepared to take on a trade. It can also come into play if the reason we entered the trade is no longer valid. This can enable us to get out of trades long before our maximum risk level is hit.

 

3.
Look at candlesticks and key price levels for logical stop placement (more on this in a moment). This means below a recent key low for a buy trade; or above a recent key high for a sell trade. Other key levels for logical stop placement: pivot points, round numbers, Fibonacci levels.

All these are tools you should be using to place your stop levels.

But, they’re not enough – because, if you’re using them, you can be sure that every other trader out there is using them too.

The stop-loss hunters

The monstrous creature known as the “stop-loss hunter” takes different forms, depending on who you’re talking to. But, whatever it looks like, it lurks around all the key price levels on your chart, waiting to kick unsuspecting traders in the shins and rob them of their lunch money.

The rise of high-speed trading algorithms which are very sensitive to trading volumes means that there are plenty of automated systems out there that know exactly where most traders will have placed their stops.

How do they know?

Well, we do tend to put them in the most obvious places.

And it’s why we see this kind of thing happen so often …

You’ll probably recognize this kind of pattern from the throwbacks and pullbacks I was talking about a couple of weeks ago.

You’ll also probably recognize the scenario from your own trading.

Three very different solutions …

One solution to this problem is to follow the methods described for trading throwbacks and pullbacks.

A second solution is to look at trading longer timeframes, where trades naturally have more breathing space. If you’re looking to make a hundred points over several days or even weeks, then chances are your stop level is nice and wide, and won’t be vulnerable to these kinds of swings.

In my opinion, the best of this type of trading is to be found in Val Harrison’s  strategy, HAV Trading – and results are proving it, with over £3,000 profit showing (on open and closed positions) since its launch in March this year. If you missed out on an opportunity to test this out – I’m hoping that we’ll be able to open the doors on HAV Trading again in the next few weeks. You can get your name on the priority list here.

The third solution is simply to widen your stops.

This may sound like a cop-out, but the truth is that with so many automated trading systems, this kind of price behaviour is on the up.

We have to be prepared to adapt

I don’t suggest widening stop levels lightly. And it’s not something to be done ad hoc, without careful consideration to your risk and your success rate.

When we’re looking to improve our stop levels, it’s important to keep our focus – we’re not interested in increasing our success rate at the cost of letting go of the reins on risk levels.

If you widen your stop level, ALWAYS reduce the size of your stake accordingly.

So, if you’re staking at £5 per point, and your distance to your stop was 30 points, then your risk was £150. If the distance to your stop has increased to 33 points, then your stake should now be £4.50 in order to maintain the same risk level.

Yes, if you widen your stop, your risk reward ratio will take a hit – but the payoff should come from an improved success rate.

For example, if your risk reward ratio goes down from 2:1 to 5:3, but your success rate improves from 40% to 45% – your overall profitability will increase.

You’ll need to monitor your results carefully to ensure that it’s having the desired effect. If you’re not already using it (or something similar), the Trader’s Bulletin electronic journal can help you here (if you’d like to download this free journal, simply sign up for the newsletter at the top of this page, and I’ll email you the download link).

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