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This week’s question comes from John, who asks:
When should a trader should move a stop loss order to breakeven?
This is one of the more common questions among Forex traders. It’s also one of the most challenging to answer because it depends on several variables.
And it makes sense that it’s a common dilemma. After all, who doesn’t want to be in a risk-free trade?
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But believe it or not, moving a stop loss too soon can be more harmful than taking a full loss.
Don’t get me wrong. Limiting losses is the key to becoming consistently profitable. In fact, it’s your number one job as a trader.
But letting winning trades run is just as important. The two go hand in hand. And if you cut off the oxygen supply of your trades by moving to breakeven too soon, you’re doing yourself a great disservice.
Your winners have to pay for your losers. That’s the key to making it in this business.
With this in mind, let’s take a look at the heavily debated breakeven stop loss. I’ll discuss my method for trailing stops as well as a few helpful hints that can keep you out of trouble along the way.
While the topic of moving a stop loss to breakeven inherits a great deal of scrutiny and rightfully so, there are two things I can say with the utmost certainty.
The first is self-explanatory. If you’ve been trading for any length of time, you know that using a stop loss is a requirement. Those who don’t are just gambling and their accounts are ticking time bombs.
The second point above is a bit more subjective.
I’ve always trailed my stops to some degree. I like the idea of locking in some profit as the market moves in my favor.
However, just like moving a stop loss to breakeven, trailing the order too soon can get you in trouble. I consider these two to be one in the same. After all, a move to breakeven is nothing more than a trailed stop.
So the question that’s really being asked here is, when should a trader begin to trail his or her stop loss?
Everything you need to know is on the chart. It doesn’t matter if you’re looking at the EURUSD, GBPUSD, NZDJPY or even stocks such as Google or Amazon. If you’re a technical trader, the answers are always present; you just have to know where to look.
Where should you look, you ask?
Start with the daily close at 5 pm EST. I don’t think I’ve ever made the decision to trail a stop loss before the session closed.
The reason I wait is due to something I call the settlement period. You see, much of the intraday price action can be deceiving. This is the very reason that pin bars on the daily time frame are so powerful.
Once the session closes, you can begin to assess the chart to determine whether or not you should move your stop.
The next thing I pay attention to are the key levels. If a pair has broken a key level of support or resistance, it may be a good time to trail my stop loss.
Take the wedge pattern that formed on the AUDUSD daily chart as an example.
Shortly after breaking below wedge support, the AUDUSD broke another support level (break #1). At this point, I could make a strong case for trailing my stop loss, which was originally above the candle that broke wedge support.
Another option would have been to trail the stop once break #2 occurred. Of course, the downside here is that your position is left exposed for an additional 24 hours.
Regardless of when you move your stop, the key here is to make sure it’s a technical decision. Remember that the market obeys support and resistance levels. Your entry point, on the other hand, is meaningless in the eyes of the market.
At the end of the day (quite literally) it’s a judgment call. You have to decide if your trade idea has progressed to the point where it makes sense to move to breakeven.
But the most important thing here is to make sure you have a technical reason for your decision. Don’t just move a stop for emotional assurance like that of knowing you’re in a risk-free trade.
While it may be great to know you can’t lose, the truth is that the market doesn’t care. It doesn’t know where you entered which makes your entry price 100% arbitrary.
That’s a significant distinction because it means that any decision to move a stop loss to breakeven for non-technical reasons is an emotional decision.
And that, my friend, is what will get you in trouble. The best way to avoid falling into this trap is to make sure every decision you make has a strong technical backdrop. In other words, pay attention to what the market is telling you.
Moving your stop loss to breakeven before the settlement period on a daily chart can lead to a premature exit, costing you potential profits.
Because of this, a stop loss order that’s moved too soon can sometimes be more costly than taking a full loss on the trade.
Let’s say you short the EURUSD, and the pair immediately drops 20 pips, so you decide to move to breakeven. But two hours later the pair has rallied back to your entry point and stopped you out.
Three days later, the EURUSD hits the target you set which was 200 pips lower than your entry. If you had used a 50 pip stop loss, that’s a 4R trade. So for every 1% of your account balance risked you would have made 4% profit.
Let’s assume a full loss would have been 2% of your account balance. On the other hand, the favorable outcome, which was a move lower, would have yielded an 8% profit.
You can probably see where I’m going with this.
Now, you could make the argument that you didn’t lose money and of course I’d agree. But you also deprived yourself of an 8% profit by moving your stop loss too early. So in essence, you missed out on an 8% profit to avoid a 2% loss.
See why that’s a bad tradeoff?
Remember that the key to making consistent gains as a trader is finding enough winners to pay for your losers.
So you see, that 8% profit could have been quite useful.
Having a stop loss in place for every trade is vital if you intend to last in this business. However, the placement of it and the decision of when or if to move to breakeven is questionable and varies depending on who you talk to.
I’ve found that assessing the situation after each daily close at 5 pm EST allows me to see things from a broader perspective. It also allows me to filter out the intraday noise which is common during times of increased volatility.
Moving your stop loss to breakeven can indeed be a viable strategy. It can protect you in the event of a sudden move against your position.
With that said, be sure that you have a technical reason for doing so. Moving a stop loss to protect your arbitrary entry point uses the same line of thinking as entering or closing a position on emotions.
In other words, let the market tell you when it’s the right time to move your stop loss. Never do it in a hurry to achieve a risk-free position. In the long run, that can be more costly than taking a full loss.
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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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