The concept of stop loss in forex is an often dreaded and uncomfortable topic in the trading community. Even the most experienced traders still hold beliefs that may actually be counterproductive.
For those looking to gain a firm grasp on their money management, avoiding the mistakes regarding the stop loss can significantly increase their chances of success. This article will cover the four common stop loss mistakes.
However, it’s good first to debunk the common myths surrounding stop losses as this will help us understand where the errors stem from and how we could correct them.
Myth #1. You can trade consistently without using a stop loss
This misconception is perhaps the most dangerous for any trader to hold for several reasons. Unfortunately, a vast number of investors still believe executing a position without a stop is better.
Holding this belief is dangerous primarily because no one knows how far a market could go against them. If we couple this with the idea most losing traders use proportionally larger position sizes than what their accounts can naturally handle, a mere 50 pip move can wipe them out.
Perhaps one could get away with not using a stop, but realistically only if they have a vast account trading micro-lots. No trader in their right mind would consider doing this since the reward is lower than the risk.
The stop loss is the bridge between comparing the risk on a trade and the potential reward. When deciding on the position size, these are always the factors to consider. Without using a stop loss, there is no quantifiable method to define a monetary risk value, meaning a trader could arbitrarily be trading a far bigger lot size than they should.
Myth #2. Brokers hunt traders’ stops
Many traders incorrectly refer to the notion of brokers hunting traders’ stops as the stop loss hunting. The concept is quite a contentious issue amongst traders, though regulated brokers don’t drive stop loss hunting; it would be bad for business and jeopardize their reputation.
Instead, stop loss hunting results from institutional traders manipulating retail trader’s positions at particular support and resistance levels through bull and bear traps. The importance of using a wider stop loss to avoid this phenomenon cannot be overestimated.
Traders who believe their broker hunts their stops typically use tight stops and never consider the volatility of the instrument they are trading.
Mistake #1. Too tight or too wide stop loss
Using a too tight stop is often a result of greed and erroneously believing one can time the market consistently. Conversely, while a wide stop loss isn’t always necessarily bad, having it too wide lessens the reward considerably.
Solution: Setting an appropriate loss is about striking a balance between not too tight that one is easily stopped out and not too wide to decrease the potential reward.
One of the best methods is using the Average True Range (ATR) Indicator, a tool reflecting the pip range a market has moved in a particular time frame.
For instance, if one was trading EUR/USD and the ATR showed 40 pips on the 4-hour time frame, this is a reasonable distance for a stop at that particular moment. We should also bear in mind that volatility changes frequently.
Therefore, the number of pips for the stop will also vary accordingly. The point is to allow for enough ‘breathing room’ before the market conclusively nullifies someone’s trade set-up.
Mistake #2. Using the same stop distance on every position
This mistake is an extension of the point on appreciating each instrument comes with its own volatility range. Using the same stop loss distance for every pair is unwise and unnecessarily increases the risk.
For instance, 30 pips on AUD/USD is not worth the same value as on a more liquid pair like GBP/CAD. Another related error is using the same lot size regardless of the instrument. Again, this mistake shows a severe lack of understanding of position sizing.
Solution: The simple fix is for traders to always use a position size calculator before taking any position. Using this tool is a calculated decision and is imperative for proper money management.
When using the calculator, one must align their monetary risk with the lot size rather than picking the latter first for the sake of trading a bigger size.
Mistake #3. Placing stops at obvious levels
By obvious levels, we mean at swing highs/lows and support and resistance levels. By looking at any instrument using any chart, we will regularly witness spikes through these structures.
In many cases, reversals tend to stem from such areas because of the stop loss hunting, as discussed previously.
Solution: This factor reemphasizes the importance of using wider stop losses. More often than not, one’s trades will be in the red and hover around noticeable swing highs/lows. Therefore, it’s crucial to add a buffer to the stop through the use of the ATR.
For instance, if a trader was trading a setup from the 30M time-frame, they may consider using the 1HR ATR; if they were trading the 1HR time-frame, they would consult the 4HR time-frame, and so on.
Mistake #4. Unnecessarily micro-managing the stop during an open position
There are two common issues with this mistake: widening the stop and closing an order before it hits a stop. Widening the stop shows a lack of discipline, planning and increases the monetary risk.
In many cases, the trader’s fears become greater to the point they will probably remove the stop loss entirely. At this moment, depending on their position size, their account may come near to a margin call.
The second problem has to do with closing a losing position before it hits the stop. By doing this, one may believe they are taking a smaller loss. Theoretically, this notion makes sense, and a trader may get away with minor losses here and there.
Unfortunately, consistently performing this action means voluntarily taking a loss even if the market hasn’t yet wholly nullified a trader’s position.
Solution: Deciding on the stop should be an informed decision where the trader is comfortable with the monetary risk and adopts a somewhat ‘set and forget’ mentality by not meddling.
A well-defined trading plan will encompass the preparation that goes behind a trade well before it comes time for execution. When a trader has this sorted, they will know to expect the worst-case scenario and not freak out.
Final word
A stop loss is not just about managing losses; it is the framework of risk-to-reward and appropriate position sizing. It is pretty hard for a vast majority to get rid of the myths and mistakes mentioned in this article as they are all too commonplace.
In some cases, a trader might only need to make a few minor tweaks to how they approach stops before seeing noticeable improvements in their performance.
