I usually kick off the Q&A posts with a question from someone. However, this week I’m going to take a different approach.
Last week I covered how to hold winning trades longer, so I thought it was only fitting to write about how to cut losing trades short this week.
After all, letting winning trades run won’t do you much good if you’re not cutting losing trades short.
In this post you will learn three methods for cutting losers short. I’ll even share how I use two stop losses on just about every trade I take.
If you combine the teachings from today’s post with last week’s topic, I can all but guarantee that your trade management skills will improve.
Let’s get started!
1. Define the Loss Upfront
You’ve probably heard the saying, plan the trade and trade the plan. It’s just as common as cut your losing trades and let your winners run.
Despite being played out to some degree, both are spot on!
However, I want to focus on the idea of planning a trade for a moment.
All profitable traders know that winning trades don’t just happen. They also know the difference between a good winning trade and a bad winning trade. The former is the result of planning, the latter relies on luck.
Anyone can get lucky in this business. After all, you have a 50/50 chance of being right every time you buy or sell.
However, the best traders understand that any profit made from a trade is the byproduct of a favorable strategy, discipline, and a plan to bring it all together.
That last part is key. If you aren’t accounting for every possible outcome before putting capital at risk, you aren’t doing your job as a trader.
Part of that plan includes defining a loss. You should ask yourself, what would the market need to do in order to negate the setup?
What if the market closes back above or below a key level? What if it breaks a certain range high or low you’d been watching?
These are all questions that need answering before you ever place the trade. As long as you plan for all the various outcomes of a trade, including a loss, you won’t be prone to making an emotional mistake.
2. Use a Soft and Hard Stop Loss
Most Forex traders are familiar with a hard stop loss. This is the order you place with your broker to buy or sell at a predetermined price in case the market moves against you.
On the other end of the spectrum is the soft stop loss. It’s also referred to as a mental stop. As the name implies, this is another level that if missed or reached, provides good reason to negate the trade setup.
How is that different from a hard stop?
It differs in the sense that a mental stop is used to exit a trade if the market closes above or below a key level.
You see, a hard stop loss can only get you out of a trade if the market crosses a certain price. But what if the market closes the day above or below a critical level without actually hitting your hard stop?
This brings us back to why you entered the trade in the first place.
Let’s take a look at an example.
The AUDUSD had closed the day below this key level several weeks prior. A short time later, a bearish pin bar developed. That was our signal to go short.
However, what actually provided the opportunity was the daily close below the key level. That’s what kicked off the search for bearish price action.
So if a daily close below the level gives us the green light to search for selling opportunities, what happens if the market closes the day back above it?
If you said, exit the trade, you’re right! That’s where a soft stop comes into play.
Instead of just using a hard stop loss order above the tail of the pin bar, you can also manually exit the trade if the AUDUSD closes the day back above key resistance. This can often be the difference between a 100 pip loss and a 50 or 60 pip loss.
Of course, you won’t always have the opportunity to exit early. There will be cases where the intraday move takes out your hard stop before the 5 pm EST session close.
The rest of the time, though, a soft stop can reduce your risk by half, or more.
Remember, I use New York close charts where each 24-hour period closes at 5 pm EST. I suggest you do the same if you’re trading price action in this manner.
3. Lower Your Risk Per Trade
I know what you may be thinking—lowering your risk won’t help you cut losing trades short. It’s more of a way to reduce your overall risk rather than to prevent a single loss from getting out of hand.
That may be true, but I’d be remiss not to point out that a smaller risk profile will help you to better manage your open trades.
If you read last week’s Q&A post, this subtopic should sound familiar.
I’m a huge advocate for risking just 1% to 2% of your account balance on each trade. Any more than that and it becomes increasingly difficult to make decisions based solely on the technicals in front of you.
For instance, have you ever gotten so excited about a potential profit that you used a wider stop loss than usual?
I know I’ve made that mistake before. It’s easy to get excited about fairytale profits when you’re risking 10% of your account balance.
But it’s just as easy to make emotional mistakes when you’re risking that much. So if you want to be able to manage your trades like a pro and cut losing positions short, be sure to keep your risk low.
How low will depend on how risk-averse you are. That said, I can tell you from experience that anything above 3% is asking for trouble.
Be sure to use this position size calculator before every trade.
Your Turn: Ask Justin Anything
I’d love for this new weekly Q&A to be successful and provide an invaluable repository of answers to common Forex questions.
To do that, I need your help.
Here’s what you can do to get involved and have your question answered in next week’s post:
- Ask questions. Post them in the comments below or Tweet them to me @JustinBennettFX
- Help me answer questions. If I missed something or if you have something to add, don’t hesitate to leave a comment below.