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So you’ve gotten yourself in a trade, now what? What Forex stop loss strategy should you use? If you didn’t know there were different stop loss strategies, that’s okay too – you’ve come to the right place!
In this lesson, we’re going to cover various Forex stop loss strategies that can be used to minimize risk and maximize gains. One strategy in particular (my favorite) will help you sleep better at night when trading the higher time frames. This isn’t your typical break even stop loss strategy, although it was derived from it.
As a forewarning, this lesson turned out to be much longer than I intended. But I can guarantee that it has some topics that will get even the most experienced trader thinking differently. Trust me when I tell you that you’ll want to read through the entire lesson and stick around until the end…that’s when things get really interesting!
So go grab a hot cup of coffee (or tea) and let’s get to it!
This lesson assumes that you’re already familiar with the pin bar trading strategy and inside bar trading strategy. If you’re not familiar with these two strategies, you may want to go study up on them and then come right back. It will make this lesson much easier to understand as we’ll be using these two Forex trading strategies as examples in this lesson.
One last thing, if you aren’t familiar with what a stop loss order is, be sure to check out this explanation over at Investopedia.
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The initial stop loss placement depends on the trading strategy being used. There’s obviously some personal preference that goes into this decision, but here are a few of the more common places to set your stop loss.
For the pin bar trading strategy, the stop loss should be placed behind the tail of the pin bar. This goes for both bullish and bearish pin bars.
If price hits the stop loss here, the pin bar trade setup becomes invalid. With this in mind, you should never think of price hitting your stop loss as a bad thing. It’s simply the market giving you feedback that the pin bar setup wasn’t quite strong enough.
For the inside bar trading strategy, the stop loss can be placed in one of two places. Either behind the mother bar’s high or low, or behind the inside bar’s high or low.
The typical (and safer) inside bar stop loss placement is behind the mother bar high or low. Just like with the pin bar, if the price hits your stop loss here, the inside bar trade setup becomes invalid.
This is the safer placement because you have more of a “buffer” between your entry and your stop loss. This is particularly useful in choppier currency pairs, where this buffer can help keep you in the trade longer.
The second stop loss placement for the inside bar is behind the inside bar’s high or low. The advantage to this placement is that it provides a better risk to reward ratio. The disadvantage is that it opens you up to being stopped out before the trade setup has had a chance to play out in your favor.
This then is obviously the riskier of the two inside bar stop loss placements. This is because there’s less of a buffer between your entry and your stop loss.
The decision of which stop loss placement to use depends on your own risk tolerance, risk to reward ratio as well as which currency pair you’re trading. As mentioned previously, the safer placement behind the mother bar is ideal in choppier currency pairs.
Now that we have a good idea of where our stop loss should be placed initially, let’s get into a few stop loss strategies we can implement once the market starts moving in the intended direction.
Can you guess what this strategy doesn’t involve? You guessed it, hands! Well I guess it does involve hands to place the stop loss. But once it’s set, its completely hands off.
Others have called it a “set and forget” strategy, which is the same principle. It’s a strategy in which you place the stop loss and let the market run its course. The key is to avoid the temptation to adjust your stop loss while in the trade.
This has several advantages. However, it isn’t not without flaw. But let’s take a look at some advantages first.
The Hands Off approach reduces the chance of being stopped out too early by keeping your stop loss at a safe distance. We all know the feeling of moving our stop loss too early and being stopped out, only to watch the market take off in the intended direction.
This Forex stop loss strategy helps to remove emotion from your trading because it involves no interaction after its set. Once you’re in the trade and have your stop loss set, you simply sit back and let the market do the work.
It’s extremely simple to implement because it’s a one-time action. You simply set the stop loss and walk away.
As previously mentioned, the Hands Off stop loss strategy is not without flaw. Let’s take a look at a couple disadvantages.
The biggest, and sometimes most costly disadvantage to this strategy is the maximum allowable risk that’s present from start to finish. In other words, if risking $100 on a trade, you stand the chance of losing that $100 from the time you enter the trade to the time you exit. There’s no chance to further protect your capital.
Using the Hands Off Forex stop loss strategy can also tempt you to move your stop loss. Of course there are always temptations in the Forex market, but leaving your stop order in one place can be emotionally challenging for even the most experienced trader.
No lesson on stop loss strategies would be complete without discussing the controversial break even stop loss. Let me start by saying that I rarely move my stop loss to break even. Why? Because the market doesn’t know where I entered a trade, nor does it care. So why would I want to move my stop loss to an arbitrary level?
Most traders who move their stop loss to break even will tell you that they do it to protect their capital. This may be true, at least on the surface. However, it’s been my experience that most traders are doing this to protect their feelings – It makes them feel safe to know that they can’t lose.
Everything we do in price action trading is based on price action levels, right? We use these levels because they’re important to the entire market. Anyone in the world can see these levels, which why they work so well.
When you use a break even stop loss, you’re moving to a level that only you know about – your entry price. Nobody else knows where you entered your trade, nor do they care.
Like most things, moving a stop loss to break even isn’t all bad…
The break even stop loss eliminates the risk on any given trade. Once in place, any market movement to your original entry will be protected by your stop loss.
Moving to break even means no market analysis is needed. The only place for you to move your stop loss is to your original entry point.
As a Forex stop loss strategy, the break even stop loss is the easiest to implement. This is because, as stated in the last point, there’s no need for market analysis. You always know exactly where your stop loss should be placed.
As you probably figured out from the intro to this section, I’m not the biggest fan of moving a stop loss to break even. Here’s why…
As mentioned previously, moving a stop loss to break even uses an arbitrary level – your entry price. I won’t harp on this again since I already covered it as part of the intro.
A break even stop loss hinders your odds of success. How? By not giving your trade setup enough breathing room to play out in your favor. The idea behind using price action confluence is to put the odds in your favor. By moving your stop loss to break even too soon, you’re not allowing these confluence factors to put the odds in your favor.
Above all, moving your stop loss to break even is lazy. How is this a disadvantage? Because it requires no market analysis, it also leaves the trader open to emotional trading.
Let me explain…
When a trader moves a stop loss to break even, they are moving to a level that they have decided is important. The market hasn’t deemed this to be a significant level in any way. This means that the only significance is in the trader’s mind, which as we all know is directly connected to one’s ego. So when the trader is stopped out at this level, he/she is much more likely to take it personal.
In contrast, the trader who uses a price action level to help determine where to move a stop loss is using a level defined by the market. In other words the trader is saying, “if the market hits my stop loss here, I no longer want to be in this trade”. It takes the emphasis off of the trader’s decision and places it on a level that was defined by price action.
So how can we protect some capital AND use price action levels to our advantage?
The 50% Forex stop loss strategy is a bit of a misnomer. Yes, it does involve cutting your risk in half (or thereabouts). But it doesn’t have to be exactly half. Let me explain.
Before we dive in, I’d like to point out that this stop loss strategy will lead to more losses vs. the hands off approach. The advantage is that we’re now starting to use the market to let us know how much capital to protect.
Let’s say you enter a bullish pin bar on a daily close (market entry). The next day, the market finishes slightly higher than our entry. Instead of moving to break even or close to it, we can now use the day’s low to “hide” our stop loss.
Here’s how that looks:
Once the market closes on the second day after our entry, we can use the low (highlighted in blue) as a place to hide our stop loss.
This allows us to cut our risk by more than 50% but still uses a price action level which is the previous day’s low. We’re essentially saying that if the market breaks the low of the previous day, I no longer want to be in this trade.
Here’s what I like about the 50% Forex stop loss strategy
The first, and most beneficial advantage of the 50% strategy, is that it cuts risk in half. If you were risking $100 on a trade, once the market starts moving in the intended direction, you could move to 50% and cut your risk to $50. Not bad!
Because the 50% strategy uses a price action level, there’s a lesser chance that the market will hit our stop loss. That’s because we’re using market highs and lows to protect the stop loss as opposed to an arbitrary level as with a break even stop loss.
As previously stated, the 50% stop loss strategy allows the market to breathe. Unlike the break even stop loss, the 50% strategy allows some room for the market to move, which is what’s needed for our trade setup to play out.
What’s not so great about the 50% Forex stop loss strategy?
Unlike the break even stop loss, the 50% strategy leaves 50% of the position at risk. This may be acceptable for some and unacceptable for others. This is where personal preference plays a role in deciding which Forex stop loss strategy to use.
Although the 50% strategy provides some breathing room, it still carries the possibility of being stopped out prematurely. This is especially true for currency pairs that exhibit choppier price action, such as the Japanese Yen crosses.
Market conditions play an important role in deciding whether the 50% strategy is appropriate. For example, if the market had closed near the low on the second day in the example above, the 50% strategy might not work. That’s because we would be moving our stop loss too close to the current market price. In this case leaving the stop loss at the initial placement might be the better decision.
In my experience, moving a stop loss to 50% when trading an inside bar setup is much riskier than it is with a pin bar setup.
The only way it can be used with the inside bar is when the trade is taken with the initial stop loss behind the mother bar’s high or low. This way when the second day closes the stop loss can be moved behind the inside bar’s high or low, provided market conditions are appropriate of course.
Here’s an example:
When the day after the inside bar closes, we could potentially move the stop loss from the mother bar’s high to the high of the inside bar. This would reduce the stop loss from 100 pips to 50 pips.
Notice the grey line I have drawn on this chart. This represents a short-term level in the market and could give further conviction to the decision to move the stop loss from the high of the mother bar to the high of the inside bar. We’re essentially using the down-side break of this short-term level as another reason to move the stop loss closer to the entry.
So let’s recap. Up to this point, we’ve covered where to place the initial stop loss, as well as three Forex stop loss strategies. The next strategy is useful once the market starts to move in the intended direction.
Now that the market is really starting to move in our favor, how should we go about protecting our capital while giving the market enough room to work? This is where the trailing stop loss comes in handy.
Before we get into the trailing stop loss as a stop loss strategy, I’d like to mention that there are two basic ways to implement this type of stop order. The first is automated, which is where the stop loss is set to trail price by a certain number of pips. Most trading platforms nowadays offer this feature. The second way is to manually trail the stop loss.
Both ways of trailing a stop loss will be explained below, but this section will only focus on the manual way. Why, you ask? Because just like the break even stop loss, the automated way of trailing a stop loss is based on arbitrary levels that have no real significance in the market.
As an example, let’s say you buy EURUSD at 1.37 and set your trailing stop loss at 50 pips. The market immediately moves in your favor up to 1.38 for a gain of 100 pips. Because your stop loss is set to trail by 50 pips, it’s now set at 1.375. So where is 1.375 in terms of other price action levels in EURUSD? Who knows…there in lies the problem.
The level at which your stop loss is trailed has no significance compared to the price action levels surround your trade setup. This is where it pays (literally) to trail your stop manually using price action levels as the basis for your decision.
The basic principle with manually trailing your stop loss is the same as the automated way. The difference is that now we’re using price action levels to determine where our stop loss should be trailed.
Here’s an example:
Now that we know where to place the initial stop loss and how to reduce some risk and lock in profit throughout the trade, let’s put it all together.
For those of you who have read the lesson on Pin Bar Entry and Exit Strategies, you know that I’m a fan of entering a pin bar trade on a 50% retrace. So what does it look like if we enter a pin bar on a 50% retrace, use the 50% stop loss strategy and then trail the stop loss behind the lows?
Note: This was actually a trade I took on the USDJPY daily chart a while back, so I’ll cover the setup and execution step by step just as I traded it.
It goes without saying that not every trade will work out this perfectly. But then they don’t have to. That’s because the amount of money you can make on one setup like this will more than pay for those setups that aren’t as perfect.
Make sure you have a fresh cup of coffee or tea because now we’re diving into the real numbers…
I entered this daily pin bar on a 50% retrace (green line) with an initial stop loss that was 35 pips away. My initial profit target was 150 pips away. So right off the bat this represented a 4.3R trade. See this lesson if you aren’t familiar with R-multiples (it’s really simple).
Although I focus on money risked vs. percentage risked, we’ll use 2.5% as the amount I risked on this trade, which is actually pretty close to the dollar amount I actually risked.
So 2.5 x 4.3 gives us 10.75%. That was the potential gain on this one trade. But it gets better, just wait 😉
On the second day (#2 above) my order to go long was filled with my stop loss 35 pips below. Once this day closed, I moved my stop loss to position #2 just below the day’s low. This immediately cut my risk by more than half. Instead of risking 35 pips I was now risking 15 pips. This brought my 2.5% risk down to about 1.07%.
Why did I do this? My thinking was that we formed an inside bar on day #2, so the market was coiling up for what looked like a move higher. I figured if there was any chance of a push higher it would come without breaking the low of the inside bar on day #2. This provided a good place for me to “hide” my stop loss to cut my risk by half.
Once day #3 closed, I was obviously in the green and had the bullish conviction I was looking for. Notice how day #3 closed – just a few pips from the high of the day. Price action signals such as this can also tell a lot about a market. The strong close on day #3 was the deciding factor for me to dismiss my profit target of 150 pips and instead trail the stop loss behind each day’s close.
There’s always some risk in doing this, but as long as the potential reward is there it can be highly profitable.
The rest is pretty self-explanatory. I trailed the stop loss behind each day’s low and ended up with a 230 pip gain. That equates to a 6.5R trade. So what was the total percentage gain?
I was initially risking 2.5% and ended up with a 6.5R trade. That’s 2.5 x 6.5 which gives us 16.25%. Not bad for 10 days of simply trailing a stop loss order.
Let me be very clear that I’m not posting this to brag or show off in any way, shape or form. The only purpose of showing this is to illustrate the power of combining the pin bar trading strategy, a proper risk to reward ratio and a solid Forex stop loss strategy.
This is the icing on the cake so to speak. Once you’ve mastered the ability to do things like define key levels, identify price action strategies, use a proper risk to reward ratio and use confluence to your advantage; a proper Forex stop loss strategy is all that’s needed to take your trading to new heights.
There is nothing complicated about this stuff. No proprietary indicators or confusing algorithms. It’s all right in front of each and every one of us. All it takes is time, discipline and the fortitude to push through the tough times – which I know you have because you made it to the end of this very long lesson.
I hope this lesson has given you some ideas on how to implement a stop loss strategy or possibly improve one that you’re currently using.
I’m sure I’ve missed something, so be sure to share your favorite stop loss strategy in the comments section below.
Need clarification on something above? Leave your question or comment and I’ll get back to you as soon as I can.
Justin Bennett is an internationally recognized Forex trader with 10+ years of experience. He's been interviewed by Stocks & Commodities Magazine as a featured trader for the month and is mentioned weekly by Forex Factory next to publications from CNN and Bloomberg. Justin created Daily Price Action in 2014 and has since grown the monthly readership to over 100,000 Forex traders and has personally mentored more than 3,000 students.Read more...
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