Why Stop Loss Could Get You Broke?

Stop Loss and Take Profit – we hate when price hits the first one and we love when it touches the other. I would be the happiest man if I wouldn’t need a Stop Loss, but I need it… or do I? According to common belief and Forex lore, I definitely need a Stop Loss. “Never trade without a SL” they say. “Oh, you will blow your account! You will be broke!” People like to sound all apocalyptic or whatever but the truth is that you can actually trade without a Stop Loss order… but not without a way to stop your loss.

 

How Stop Loss Could Get You Broke?

The main purpose of the Stop Loss order is to limit your losses and to keep you in the trading game for longer. Unless you’ve developed a way to know with 100% accuracy where the market is going (in which case, I’ll buy you a beer to tell me how), you need a way to cut your losses. The easiest way to stop a loss is to use a Stop Loss order (duh!) but sometimes the positioning of that order is the biggest problem for traders. Where should you place your Stop Loss? I believe that the best place is above/below the thingy that made you enter the trade. Let’s assume you trade using trend lines and you see a nice bounce on a bullish trend line. Ok, so you have entered your trade assuming that trend line holds and pushes price higher. In my opinion, when the reason that made you enter is gone (i.e. the bullish trend line is broken), that’s when you must close your trade. In this case, the Stop Loss should go below the bullish trend line, with enough room for price to move:

 

 

The green zone can be considered a good bounce and the Stop Loss (red line) is placed below it, but not too tight. If price would reach it, then the trend line would definitely be broken and thus my reason to go long – gone. Why stay in the trade if I don’t have a motive? Same with Moving Averages: if you trade bounces, breaks or crosses, when the opposite event occurs, I close my trade manually or it’s automatically closed because my Stop Loss is already placed on the other side of the MA. This style of thinking can be applied to chart patterns (if you are going short based on a double top, your Stop Loss goes above that double top), histograms (if your trigger is a histogram that goes above/below a certain level, close the trade if the histogram reverses above/below that level) and basically any type of trade entries. Bottom line is: if I entered because X event happens, I want to exit when and if that event is invalidated.

There’s one more important decision that needs to be made when placing a Stop Loss how many pips are too many? I believe that decision should be only made based on the market and never on your position size. In other words, adjust the position size to fit the Stop Loss, not the other way around! Yes, I will explain: let’s assume that based on the current market structure, a good place for your Stop Loss is 50 pips above entry price but with your current position size 50 pips means 500 dollars and you cannot afford to lose that much. Here’s what you DON’T do (in fact, I don’t; it’s your money): do not use a 25 or 30 pips Stop Loss just so you lose less. Instead, lower the position size but place your Stop Loss where the market demands it. Sure, you will make less money, but you cannot bend the market around your needs!

 

Behold! The Myth of the Stop Loss Order – Destroyed

In the beginning of the article I’ve told you that you need a way to stop your loss, not necessarily a Stop Loss order so I think I owe you an explanation. Just how there’s more than one way to cook an egg, you can stop your loss without using a classic Stop Loss order. Think about this: you need a 50 pips Stop Loss but instead of placing Stop Loss order, you place a pending order which is opposite of your current trade, with the same size of course. Say you Sell 1 lot at 1.3100 and instead of placing a Stop Loss at 1.3150, you place a pending Buy order (also 1 lot). If price hits 1.3150 and triggers the Buy order, it will “lock” your loss because if price goes to 1.3200, your Buy order will be in profit and that profit will offset any losses above 50 pips. Excluding spread and other trader related expenses, you will be always at -50 pips net (at 1.3200 your Buy is +50 and your Sell is -100). Does this destroy the Stop Loss “myth”? Not really, but it offers an alternative to it because after all, a “locked” position cannot lose more than you want it to and can be unlocked at any time by closing either the Sell or the Buy and letting the other run (with a classic Stop Loss or maybe another opposite pending).

 

The Lesson to Be Learned

Never get caught with your pants down - I believe that’s the most important lesson to be learned here. Whether you trade with a classic Stop Loss order, a mental one (manually close the trade when you consider it necessary) or an opposite, equal size pending order it’s up to you but never trade without having a plan for when things to sour. Always start your trade knowing where you are gonna cut your losses. Make your decisions before opening the trade because once it’s open, all sort of emotions will take over and you might do stupid things that can get you broke.