Let’s look at the four most common blunders traders make when employing stop losses.
We always emphasize the need of risk management, but when done incorrectly, it can result in more losses than successes. And do you really want that?
1. Placing Stops Too Tight
When you place ultra-tight stops on trades, there will be insufficient “breathing room” for the price to move before eventually coming your way.
Remember to account for the pair’s volatility and the fact that it may linger around your entry point for a while before continuing in a specific direction.
Assume you entered a long GBP/JPY position at 145.00 with a stop at 144.90.
Even if you are correct in your prediction that the price would bounce from that position, there is a chance that the price will sink 10-15 pips lower than your entry price before popping higher, most likely till 147.00.
But guess what?
You didn’t make a 200-pip profit since you were stopped out in a flash. So keep in mind:
Remember to give your trade some breathing room and allow for volatility!
2. Using position size like “X number of pips” as a basis for stops.
Using position size such as “X number of pips” or “$X amount” to calculate stops instead of technical analysis is a BAD idea.
Remember how we learned that from Newbie Ned?
Using position sizing to calculate how far your stop should be has nothing to do with how the market is acting!.
Given that we’re trading the market, it makes far more sense to establish stops based on how the market moves.
After all, you choose your entry point and targets based on technical analysis, so why not your stop?
We’re not saying you should disregard position size entirely.
We propose that you decide where you want to put your stops before estimating your position size.
3. Placing Stops Too Far or Too Wide
Some traders make the mistake of putting stops that are far too far away, hoping that market action would eventually move in their favor.
So, what’s the point of putting stops in place?
What’s the sense of hanging on to a losing trade when you may utilize that money to enter a more successful deal?
Setting stops too far out increases the number of pips your trade must move in your favor to be profitable.
Stops should be placed closer to the entrance point than profit targets.
Of course, you’d like a lower risk and a higher reward, right?
With a favorable reward-to-risk ratio, say 2:1, you’d be more likely to earn if your trades were correct at least 50% of the time.
4. Placing stops exactly on support or resistance levels.
Stops that are too tight? Bad.
Setting too many stops? Bad.
So, where should a suitable stop be placed
We can inform you that it’s not exactly on support or resistance levels.
Why is this so?
Didn’t we just mention that when it comes to selecting stops, technical analysis is the way to go?
When selecting where to place pauses, it’s useful to take note of surrounding support and resistance levels.
If you’re going long, simply look for a nearby support level below your entry and place your stop there.
If you’re going short, determine the next resistance level above your entry and place your stop around there.
But why isn’t it a good idea to put it right on the level of support or resistance?
The rationale for this is that the price may still have a chance to turn and travel in your favour once it reaches that level.
If you place your stop a few pips beyond that area, you can be fairly certain that the support or resistance has already been broken, and you can then admit that your trade concept was incorrect.