USING STOP ORDERS IN FOREX TRADING - Lesson 6
In this lesson you will learn:
- The importance of Stop Orders
- How to calculate Stop Orders
- Different types of Stops used in trading
Stops should be used as a part of the trading plan, in order to gain control of the losses that a trader may experience. They are a crucial aspect when aiming for trading success. We cannot control market behavior or the price, but we can exercise self-control and discipline.
How to Calculate Stop Orders
Where to place a stop loss order on a chart in undoubtedly a skill that requires research, practice, understanding and concentration. Traders may place a top using a percentage of their account as a loss or look for a level where they are convinced the price at the given moment is representing a prevailing change in market sentiment, perhaps from bullish to bearish.
As a general guideline, for example, when buying a currency, the stop loss should be placed below a recent low price bar. The price selected will vary on individual strategy, however should the price drop, the placed stop should be activated and the trade closed, preventing further losses.
Traders should evaluate the risk percentage they are willing to take and take into consideration the number of pips from the entry price in order to determine where the stop should be placed. For example, a swing trader may have decided to place the stop loss order at the daily low of the previous day, which may be 75 pips. By using a position size calculator and choosing the risk percentage, the trader will be able to establish the exact points per pip he will be trading for the particular trade.
Different Types of Physical Stops
There are three key stop loss methods traders can use: percentage stop, volatility stop and time stop.
Percentage Stop
As previously mentioned, a trader may decide on the certain risk percentage of the trading account on which the stop will be based. As a swing or day trader, on may recognize a recent pattern of market behavior that illustrates price stalling, therefore a possible reversal opportunity may be forming. Price may continuously reach an area but failing to break through, with price rejecting the area and in increasing pips. Therefore, a stop may be placed at the key repeating areas.
Volatility Stop
This stop would be used if a trader is concerned that the price would suddenly break out above the range. The trader further believes that should the price break out above the level which was set previously, it would indicate a dramatic change in market sentiment. In order to set the stops, various volatility indicators can be used, such as Bollinger bands and ATR, so as to establish the average range of a forex currency pair. There range indicators can be used to set the stops at the extremes of price movement, at the points where the volatility is in effect.
Time Stop
When using Time stop, a trader is looking to place a limit on the period of time he is prepared to wait before determining that the trade set up is invalidated. Term ‘fill or kill’ is often used in relation to this type of trading. A trade is either executed or cancelled and a time period can also be attached to its execution.
An example of setting a time stop can be related to the times when forex markets are most actively trading. A scalper or day trader may not be comfortable holding trades opened overnight. Therefore, all trades will be closed once New York equity markets close for the day.
Time stops are often used by experienced traders in order to avoid holding trades over weekends, as there are often gaps and high volatility in thin markets, when the Asian session opens on Sunday evening.
The Use of Trailing Stop
Traders prefer to use Trailing stops as they trail the trade as it develops and the benefit is locking in the gains. For example, if a thirty pip trailing stop order is placed and the trade profits 30 pips, a trader is in the position of being in a risk free trade. The stop will be moved 30 pips to be at the point where if price suddenly reverses by 30 pips, the trader would break even. The overall maximum 30 pips for example, can be chosen, however different increments by which the trailing stop moves can be set as well, generally in ten pips amounts.
Mistakes to Avoid when using Stops
Using stops when trading is an essential ingredient required to progress in trading. However, it is important to keep in mind that by nature, markets are unpredictable and no matter how well the stops are calculated there will be times when the markets may move too sudden and our stops will not be able to protect us.
Nevertheless, traders have to keep in mind the following mistakes when using stops in trading:
Placing Stops too tight to the Current Price
This is the most comment mistake a trader can make. By placing the stop too close to the current price the trade is not allowing sufficient room for the trade to fluctuate. It is advised to practice placing the stop and develop the required skill in calculating where the stop should be placed.
Setting Stops at Resistance and/or Support Levels
A common scenario is for the price to move away from the daily pivot point and hit the first level of resistance or support, and immediately reject this level and move back through the daily pivot point. Therefore, if the stop is placed at resistance or support level, the trade will be closed and the opportunity for continuation and possible gain will be lost.
Widening Stops for Fear of Losing
Rather than simply accepting that the trade did not go into our favor, traders may see price threatening the stop loss order, panic and widen the stop to accommodate the move. This represents a pure lack of strategy.
If the analysis is done correctly and the stop loss point is established, then abandoning the strategy may possibly lead to greater losses.
