Let’s begin with the most fundamental sort of stop: the percentage-based stop loss.
The percentage-based stop employs a set percentage of the trader’s account.
For example, a trader may be willing to risk “2% of the account” on a trade.
The percentage risk varies depending on the trader. More active traders may risk up to 10% of their account, but less aggressive traders often risk less than 1% every trade.
Once the % risk is estimated, the forex trader utilizes his position size to calculate how far out from his entry he should set his stop
Isn’t this great?
A trader is establishing a stop loss in accordance with his trading strategy.
Isn’t this good trading?
WRONG!
Always set your stop loss based on the market situation or your system rules, not how much money you want to lose.
We’re sure you’re thinking, “Huh? That does not make sense. I thought you meant something about risk management.”
We agree that this sounds perplexing, but let us illustrate with an example. Don’t you remember Newbie Ned from your Position Sizing lesson?
Ned, a newcomer, has a $500 micro account with a minimum trade size of 10,000 units. Ned, a new trader, chooses to trade GBP/USD after noticing that resistance at 1.5620 has been holding.
Ned will risk no more than 2% of his account per deal, according to his risk management standards.
At 10k GBP/USD units, each pip is worth $1, and 2% of his account is worth $10.
Ned’s maximum stop is 10 pips, which he does on this trade by setting his stop at 1.5630.
However, the GBP/USD pair fluctuates more than 100 pips per day! He might simply be stopped out at the slightest movement in the GBP/USD.
Because of the position limits on his account, he bases his stop on how much he wants to lose rather than the current market conditions of GBP/USD.
Let’s wait and see what happens next.
And then, wham! Because his stop loss was too tight, Ned was stopped out right at the top! Aside from losing this trade, he also passed up an opportunity to gain almost 100 pips!
The danger of utilizing percentage stops, as shown in that example, is that it requires the forex trader to put his stop at an arbitrary price level.
That stop will either be too near to the entrance, as in Newbie Ned’s instance, or at a price level that disregards technical analysis.
For all you know, you could be placing your stop just at the point where the price will turn and move in your favor (who hasn’t seen it before?).
But you wouldn’t be able to bag those pips because you were already stopped out! Oh, no!
Ned’s solution is to find a broker who matches his trading style and beginning capital.
In this instance, Ned should use a forex broker that offers micro or even bespoke lots.
Each pip is worth $0.10 at 1k GBP/USD.
To stay within his risk tolerance, Ned might set a stop loss on GBP/USD at 100 pips before losing 2% of his account.
The calculation is as follows: 100 pips x $0.10 = $10.
He can now tailor his stop to the market situation, trading strategy, support and resistance levels, and so on.
