Forex Trading And Setting Stops Losses, Part II

We left off last time talking about setting short stops on smaller time frames.

So just to recap, a smaller time frame of less than an hour should have a price target of 20-30 pips. That means that my stop loss should only be half that, or 10-15 pips. Once you calculate in the spread, say 3 pips on the euro, or 5 pips on the sterling, you are only allowing yourself a movement against you of 10-12 pips. Frankly, that's pretty slim. You will find yourself getting knocked out a lot if you are not careful. If this is the way you really want to trade, the best advice I can give you is you MUST enter your positions near the swing highs and swing lows. That means you must enter based on fixed predetermined points (usually predicted either by pivot calculations or by Fibonacci grids). If you are not familiar with those, it will be very difficult. Many newbie traders I have known, try using candlestick patterns with these short term trades. That was what they were taught by some heartless FX system seller. However, many candlestick patterns need at least 2 complete candles to be verified as a pattern. So you have your 1st candle which shows reversal, then the next candle makes it complete. By that time you will have often moved 10-15 pips. You must move your stop beyond that swing point, then add in your spread, and suddenly, your trade no longer looks all that attractive. In that case, you have to be a good enough trader, that your skills can lead you to a 65-70% win rate. Anything less and you will consistently lose money.

That leads us to our next option...trading longer term charts with wider stops. It has remained part of my mission to preach this kind of trading to traders. Trading this way will do two things for you (if you're smart). First, it won't set you up for "Failure in 15". That's what I call getting taken out in one 15 minute bar on a small trade. You've entered what looks tempting, but in less than 15 minutes, you're a loser. So many newbie traders will do that 2-4 times a day before throwing in the towel. Then they'll come and do it again the next day. It's suicide. Second, it will force you to "gear down" your leverage. Many newbies come to the market with $5,000 or less. If you have a stop loss that is 100-150 pips, you certainly will not be trading a full size lot (if you know what's good for you). A bad trade can wipe out 30% of your account. And the corollary is this; now you have to make back more than 40% just to break even. Another bad trade may put you down to $2,000. Now you need 60% to break even.

So enlarge your stops. Gear down to where when you look at the stop and calculate its distance from your entry, that you are not risking more than 5% of your total account. Thus, if you are on a $5000 account, 5% is going to be $250. If your stop is 150 pips away, you can set your pip size to $1.50. That will give you the staying power to hold your trade, and not have a gut wrenching loss if it should move all the way against you.

Also, stops should be set, not only according to what you're willing to lose, but in tune with the markets rhythm. If a 150 pip stop is still below the last swing high, then you stop is too close. Stops should be outside of the recent swing highs and lows. It is at that point that traders will be looking to enter positions going in the opposite direction. It is at that point when you would know that your choice of direction is incorrect. A stop loss of 200 pips is not too much if you are on a daily chart. Especially, if you have a profit target that is 300-400 pips or more.

Another means of selecting a stop is by using the Average True Range indicator. The ATR calculates the range of the average bar on your chart for a select amount of periods (the preset on MT4 is 14, but you can set it to any amount of periods that you like). Let's say you are looking to short a market, and it has had a nice run up. Then maybe shows an exhaustion type candle (short body, long upper wick), you can enter a trade when the next candle breaks below the low of the exhaustion candle, use the ATR to calculate an average range, add that to the top of the exhaustion candle, and you have another viable stop loss price. Generally, this calculation results in a shorter stop loss distance, thus a smaller loss for you if the market does not go in your intended direction.

I think that will do it for today.

Happy Trading!

Bill

Drop me a line at bill@thefxtradingmasters.com if you have any questions!