Stop placement and stop loss orders are among the most controversially discussed trading concepts and there are a lot of misunderstandings and wrong ideas floating around the concept of stop loss orders. In this article, we are not going to provide specific stop loss strategies, but we take a look at general stop loss principles that can help all traders improve how they approach their trading immediately.
#1 Not having a stop loss
Let’s start with the biggest problem of not having a stop loss in the first place. If you are trading spot (which most people do), then there is no reason for why you should ever be in a trade without a stop.
In its purest form, a trade represents an idea/opinion about a potential scenario that is based on your strategy’s rules and the chart context. Your stop loss is the place where your idea is proven wrong – and nothing else, although many traders see stops as their enemies. A trader who is in a trade without a stop hasn’t done his homework and he often tries to avoid to be proven wrong.
#2 Sizing positions is impossible without a stop loss
Furthermore, if you don’t have stop loss, you can’t size your position and you can’t control risk. Many people will argue otherwise but it’s the way it is. The stop loss distance defines how many contracts you have to buy/sell to achieve a certain risk.
Without a stop, it does not really matter how big your position is because your risk will be all over the place.
#3 Mental stops don’t work in Forex trading
Traders who use mental stops often do so because of the ‘flexibility’ mental stop loss orders give them – or so they tell themselves. A mental stop loss does not have a single advantage over a hard stop: traders who use mental stops stay in losing trades longer, size positions incorrectly and increase their risk unnecessarily.
#4 The wrong stop loss placement sequence
For the reasons above, you always have to know where your stop goes BEFORE you enter a trade. The stop loss distance then tells you how many contracts to buy/sell for your desired risk exposure.
In Forex trading, many people make the mistake of buying a fixed amount of contracts and then adjusting their stop based on the risk they want to have. Then, their stops end up in random places that absolutely make no sense in the market context.
Stops ALWAYS go first.
#5 Obvious stops without breathing room
How often did you enter a trade and thought the setup looked great and then price went straight to your stop loss before going to your take profit without you? This is a common scenario many traders deal with on a daily basis and very often traders then think that they should trade without a stop – bad idea!
If you repeatedly see that your stops get hit precisely before price reverses into your original direction, it’s very likely that you place your stops at levels that other traders also use. Especially if you trade the obvious price action patterns, it’s very easy to spot amateur entries in Forex trading and the professionals know where the stops will be.
#6 You widen your stop loss
This is another cardinal sin of stop loss placement. When traders are not ready to take a loss, they often widen their stop loss orders to ‘allow their trades to turn around’ because they still believe (read: hope) that their analysis was right.
This is especially common when traders don’t use ‘reasonable’ stop levels (see point #2). If you have problems with widening your stops, close your Forex trading platform once you are in a trade and remove yourself from the screens. This can help build trust in your system in the beginning.
#7 Stop trailing and break even stops
Although stop trailing comes with good intentions initially, it’s very easy to ruin a potentially good trading strategy by incorrectly trailing stop loss orders. The idea of a trailing stop is it to protect your position and also to stay in trades longer when you catch a momentum wave.
The reasons why trailing stops usually don’t work is because traders trail their stops based on fear and greed – they move stops too fast because they want to create a ‘risk-free’ trade and avoid giving back profits.
Just pull up any price chart and you’ll see that price always moves in waves – a trader who trails his stops too fast and too close behind price does not take this natural behavior into account.
Conclusion: stops are the most misunderstood trading concept
It’s surprising how wrong the perception of the usage of stop loss orders is in Fore trading. Whereas most traders treat stops as something that works against them, trading without a stop loss is a clear sign that a trader isn’t professional enough and hasn’t fully understood the true meaning of a stop loss order.
Stop loss disclaimer: The placement of orders by you or broker, such as a “stop-loss” or “stop-limit” orders, will not necessarily limit your losses to the intended amounts, since market conditions may make it impossible to execute such orders.