November 20, 2007

Stop Losses: Determining Your Optimum Stop Loss Strategy

If you want to become a successful forex trader then it's imperative that you develop your own stop loss strategy. Stop losses are incredibly important because they protect your trading capital and limit your losses. 

A profitable trader's account will either contain lots of small losses but plenty of bigger gains which more than compensate for the losses, or they will have similar sized gains as the stop losses but more of them so they are in profit overall.

For example, a trader may have a stop loss placed at 10 points away from entry each time, but has much bigger targets of 20+ points, for instance, or he may even let his winners run for as long as possible.

Alternatively he may have a stop loss of 10 points but also looks for 10 points profit from each trade, so in this case he needs a win ratio of over 50% to be profitable.

The hard part is of course determining your optimum stop loss strategy.

You also need to first of all be making some decent profits from forex trading. This way you can really analyze your trading and scrutinize your exit points and stop loss limits.

The perfect stop loss strategy should basically be at the point where you can admit that your initial trade was wrong, and the criteria that made you enter the trade no longer apply.

An example of this would be if you were going long on a rising moving average. A good stop loss here would be at a point just below the rising moving average because if this subsequently occurred then it is evident that the rising trend has come to an end and your reasons for entering the position no longer apply.

You should however be careful not to place your stop losses too close to your opening position, particularly in short-term volatile markets. You need to give your positions chance to breathe.

Your optimum stop loss level should be at a point where you can safely say that your initial entry has gone against you and it's time to get out, without being too close, but it should also be at a point where it's statistically unlikely to turn around and bounce back into profitability.

For example, a while back I used a stop loss of 20 points when trading GBP/USD (including the spread so the price would have to move 17 points to trigger my stop loss) with target profits of 10-60 points each time. However after analyzing my records I discovered that this stop loss was slightly too far away because it hardly ever bounced back from 14+ points away so why have a stop loss of 20 points?

This was just throwing money away so I reduced my stop loss to 14 points and noticed a significant increase in my profits and have stuck with it ever since (although I am constantly tweaking my trading strategies).

One final point I want to make is that you should study the behaviour of the different currency pairs you are trading because you will often find that you need slightly different stop loss levels for different pairs in order to make maximum profits, as they all behave differently.

The key point is that you have to find your ideal stop loss strategy because trading with random stop loss levels or worst still no stop losses at all will really hold you back and will make it extremely difficult to make consistent profits from forex trading.

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