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This week’s question comes from Taylor, who asks:
What’s the best way to trail my stop loss when trading Forex?
One of the hardest parts of trading is knowing when to trail your stop loss.
Trail it too soon and you get stopped out prematurely.
Trail it too late and you take an unnecessary loss.
Lucky for you, today’s post is going to break it all down. By the time you finish reading, you’ll know your options and the pros and cons of each.
I’ll also share the process I use for deciding when and where to trail my stop loss.
Last but not least, I’ll give my thoughts on the notorious breakeven stop loss.
When facing any decision in life, it’s a good idea to take a step back and look at your options. It helps add structure to the decision and often presents the best choice with little effort.
As traders, we have three options when it comes to using and trailing a stop loss.
Although number three is an option, it isn’t one I’d ever use or recommend.
I’m including it because I receive far too many emails each week from traders who’ve lost a substantial sum of money by not using a stop loss at all.
All I can say is, don’t make that mistake. Not only does a stop loss order help protect your capital, but it also allows you to size your position properly.
So that leaves us with numbers one and two from the list above.
While the first option is certainly better than the last, I can’t think of a recent situation where I used a stop loss but didn’t trail it once the market started moving in my favor.
However, timing is key. Move it too soon and you get stopped out before the trade ever had a chance. Move it too late and you’ll take an unnecessary loss.
So now that we know our options, let’s discuss some specifics.
I often talk about the process of good trading. The truth is, it’s a combination of several processes working together. One of those processes deals with using and trailing a stop loss.
Now, I won’t discuss the initial stop loss placement much in this post. I wrote an entire lesson on the subject, which you can read here.
The general idea behind the process below is that by following the market’s movements, you’ll be able to decide when it’s time to move your stop loss. This makes sense because it’s precisely the same as placing your stop on the initial setup.
Without further ado, here are the three steps I follow when trailing my stop loss.
If you’ve followed me for a while now, you’ll know that I mostly use the daily time frame. Since I trade with New York close charts, it means that each 24-hour session closes at 5 pm EST.
Not only is this important when scanning for buy and sell signals, but it’s also essential when trailing your stop.
Provided you’re trading a market that has momentum, you’ll want to wait for the market to close above or below the next key level before getting too aggressive with moving your stop loss.
Take the EURUSD daily chart below as an example.
While the market was somewhat sideways prior to forming the bearish pin bar above, the intermediate trend was pointed lower.
Note that when trading a pin bar, your initial stop loss should go above or below the long wick. See the chart above.
Now, when trailing your stop, it’s important to wait for the market to present the opportunity. And if you’re an end-of-day trader like me, that requires waiting for the day to close below the next key level.
The daily close below the next key level confirmed the break. That completes step one of our three-step process.
Notice there’s a lot of waiting here. That is deliberate.
When you’re trading the daily time frame, it sometimes takes days before you can safely begin to trail your stop loss order.
Again, the goal is not to break even as soon as possible. I apologize in advance if this sounds offensive, but moving your stop when you’re in profit by 10 pips is a rookie mistake.
If you do that on the higher time frames, I can just about guarantee you’ll get stopped out too soon.
The purpose of waiting for the retest is two-fold…
Let’s take another look at our EURUSD example.
Notice how after I entered short, I waited for the pair to close the day below the next key level. I then waited a few more days for the market to retest the broken support level as new resistance.
You could also trail your stop above the first bearish candle following our pin bar. That’s a perfectly viable option. However, it does leave your stop order exposed which can be a drawback, particularly in volatile market conditions.
I’ll admit that this is a relatively conservative approach. You don’t necessarily have to wait for a break and retest to trail your stop, but it will give you the best chance of allowing the market to work for you.
The last step involves actually moving the stop loss order. The exact methods for this vary by trading platform, but many of the newer ones allow you to simply drag the order to the new position. Be sure to check with your broker if you’re unsure.
The position of the new stop loss depends on how the market retested the level in step two. Ideally, the order should always be placed at a level that would negate the trade idea, if achieved.
Let’s go back to the EURUSD example.
Upon retesting the key level as new resistance, the pair sold off quite aggressively. My stop loss would now go approximately 10 to 20 pips above the high of that candle.
At this point, if the euro were to rally and take me out of the position, there’s a good chance it would continue higher so the positioning above makes sense.
You continue to do this until the market either reaches your target or hits your stop loss. Notice how EURUSD behaved the same way following a subsequent close below the next key level.
To be clear, there is no way to know if the market will move beyond the first support or resistance level. You’ll need to use what you’ve learned about price action to determine whether momentum is strengthening or waning.
If you’re trading a strong trending market, you can use a two-candle rule to determine when to start trailing your stop loss.
Allow me to explain…
The first step is to wait for two 24-hour sessions to close following your entry. During this time, your stop loss remains in its initial position.
Provided the market is still trending in your favor, you would move your stop above or below the daily candle that formed after your entry. In other words, your stop order will always be at least 48 hours behind the current price.
By waiting for two daily candles to close, you allow the market to move away from your entry. Again, this only works well in a trending market.
You can make it three, or even four candles if you want. There’s no hard and fast rule here, as it comes down to whatever works best for you. It will also depend on your anticipated holding period.
Just know that a three-candle close may allow you to stay in the trade a little while longer. However, it also means you could give up more unrealized gains, should the market reverse on you.
Let’s imagine for a moment that you just sold the EURUSD. After a few hours you check back in to find the pair has lost 30 pips.
Apparently, the ECB dropped a bombshell that didn’t sit well with Euro bulls. That’s good news for you.
It’s getting late so you decide to trail your stop loss to break even before going to bed.
The next morning you roll over to look at your phone and see an alert from your broker that your stop loss order was triggered.
Bummer. But hey, at least you moved that stop to breakeven, right?
You finish your morning routine and decide to check on the markets. To your dismay, you find the EURUSD trading 100 pips lower from the breakeven stop loss you set the night before.
Upon seeing this, you decide to sell now. You’ve already missed 100 pips and you sure as heck aren’t going to miss out on the rest of the move.
By the end of the day, the EURUSD has bounced by 40 pips. Not wanting to hold the position overnight, you decide to get out for a loss.
You went to bed the night before with thoughts of profits, woke up with no profits, and now you’re about to go to bed with a loss of 40 pips.
Does any of that sound familiar?
I’ll bet it does. Even writing this scenario takes me back to my early days when I’d trail my stop too soon and take trades based on the fear of missing out (FOMO).
So what’s the solution?
Simple. Give the market room to breathe. Don’t make the mistake of moving your stop loss too soon, simply to avoid a loss.
Instead, listen to the market. It will always tell you when it’s time to begin trailing.
Trading is a balancing act. Although your number one job as a trader is to protect your capital, your second most important job is to let winning trades run.
You can accomplish both by reducing your risk. If you’re only risking 1% or 2% of your balance on each trade, you’ll be much less likely to trail your stop loss too soon.
By reducing your risk, you’re effectively protecting your capital and increasing the likelihood that you’ll let winning trades run.
Like most things, there is no right or wrong answer here. It comes down to what you prefer and what gives you the best chance of coming out ahead in the long run.
Remember that your number one job as a trader is to protect your capital. That can’t be overstated. One way you can do that is by using a stop loss order on every trade.
Whether you trail it or not is up to you. However, knowing that protecting your capital is a priority can serve as a guiding light. In most cases, you’ll find it appropriate to trail your stop loss, at least to some degree.
It’s a balancing act though. You need to trail your stop to protect your capital, but you also don’t want to suffocate your trade by moving it too soon. After all, your winning trades have to pay for the ones that lose.
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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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