Placing Better Stops in Forex Trading

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Scott Percival

15 Mar, 2007

in Forex and 2 more

Introduction
The importance of well-placed stop orders to a FOREX trader cannot be over emphasized. The margin percentage required in a typical FOREX account is so small that a fully leveraged trader could easily lose a substantial amount of their net worth from a single position if it moves too far in the wrong direction. The name of the game is risk control and the key tool for protecting your account from substantial losses is the stop order.

That being said however, I do know some traders who claim never to place stops. Usually the rationale for this is that their trades are very short term (on the order of just a few minutes) and they are watching the market during the entire trade, finger twitching on the exit trigger ready to bail out at the first sign of trouble. Even when I counter this with arguments that a stop will provide the discipline needed to avoid the "deer in the headlights" syndrome or that stops can protect them when their system crashes, I still meet with stern resistance to the use of stops. Eventually I came to understand that this resistance can stem from the frustration of being stopped out of good trades much too often.

And frustrating it is! In 2004 I opened up my first FOREX account with just a few hundred dollars in order to test out the waters a bit. I figured, "OK, how hard can this be? I'll just set my targets at three times the distance to my stops so I'll have a 1:3 risk/reward ratio. Then, all I need to do to make a profit is be right more than 25% of the time on my trades. Any dolt can do that, right?" Well this dolt apparently couldn't, because about a dozen trades later I think I may have hit my target about twice. Every other trade was stopped out. Unbelievable. What was happening?

There are a couple of possible explanations for this. The first and most obvious is that I was simply setting the stops too close. This may have allowed the random "noise" of the price movements to trigger my stops. Another possibility is that either my broker's dealing desk or some other heavy hitter in the market was engaging in "stop hunting". I've written a more complete article on this subject already, but basically this involves market players who try to push the price to a point where they think a lot of stop loss orders will be triggered. They do this so that they can either enter the market at a better price for themselves or to cause a snowballing move in a direction that benefits their existing positions.

Let's deal with the first issue of placing stop orders too close. Traders may do this for a couple of reasons. Some may do it because they are following a risk control rule involving the maximum loss that they are willing to take, while others are simply choosing inappropriate places on the chart for the stop. We'll look at each of these cases in detail.

Stop location determines position size, not the other way around!
Money management and risk control rules are great, but make sure you apply them in the correct sequence. Let's say you have a rule that you will risk no more than 1% of the account equity, or $50, on a single trade. You decide to take a short position on 10,000 NZD/USD at 0.6600 which means that each pip of movement will equal $1.00. So your stop should be 50 pips back at 0.6650 right?

Well actually...not really. This reasoning is backwards. We took our money management rule and our position size and used those values to calculate our stop loss point in the market. But this doesn't really make sense because why should the market care what your rules and position size are?

We really should be placing the stop loss at some logical place based on the chart. Let's say we look at the chart and see that a good place for a stop would actually be 80 pips back at 0.6680 (we'll discuss how to find good places for stops next). This presents a problem because if our position size is 10,000 then our potential loss is $80 which violates our money management rule. That's not acceptable, so how can we put the stop at the stop at the logical point of 0.6680 while still only risking $50? Well, we only have three variables to work with and we've already decided on our maximum loss and stop location. The only other thing we can change is position size, and that's what we need to do. If we cut our position sized down to 50/80 x 10,000 = 6,250 then we're all set. We can put our stop in a logical place, while still following our rule of only risking $50.

In summary, let your stop location determine your position size, not the other way around!

Where should the stop be?
Every trader will have different methods for placing stops, but a common theme among many of them is that a stop should be in a place where it will only be hit if you are obviously wrong about the trade direction. Many traders just look for the nearest local high/low or resistance/support line and place the stop on the other side of it. However, prices exhibit false breakouts all the time, so just because one of these obvious support/resistance points is breached does not mean that the price will continue in that direction.

So how do you find that place that indicates that the price is "obviously" going against you? Do this by pretending that you are considering placing a trade in the other direction. What kind of price action or indicator signal would tell you that the trade was headed in that direction? What would you need for confirmation? For example, suppose your actual trade is going to be a long position on the USD/JPY at 118.40. There is a recent double bottom down around 118.10, and most traders will probably place their stops a little below that. However, you begin thinking about what would make you want to go short the pair. You might think, "Well sure, if it breaks that double bottom that would get my attention, but that's not enough. It would probably have to retrace a bit first forming a lower high, and then move down past this consolidation area here at 117.90 for me to be really convinced of the downtrend." Now you've found a place where the price should definitely not be if you're right about the long trade. So put the stop down there, and there will be less chance of it getting hit.

Of course you don't have to use chart patterns to do this. You can use any indicators that you're comfortable with to go through a similar procedure. Suppose you like moving averages. You might decide that if the 10-bar MA crosses below the 50-bar MA then that would definitely indicate a downtrend. As you look at the chart, you see that this crossover wouldn't happen until the price reached about 117.75, so maybe that's a good place for the stop. You could use Fibonacci retracement levels, Bollinger bands, or many other tools to go through a similar thought process.

The point is to place the stop at a place where you would be totally convinced that the price is going in the direction counter to your trade. Don't place it in the obvious places with everyone else's stop!

Don't fight the "stop hunters." Join them instead!
One of the main reasons you don't want to have your stop in an obvious place like just behind a local peak/valley or right at a nice round number is that stop hunters will often try to trigger stops in those locations. I've discussed how and why they do this in a previous article, so now let's look at how you can take advantage of this practice yourself.

In that previous article, I described a trade where I was convinced that the AUD/USD was going to head much lower from the 0.7540 area. There was a local top near 0.7570, so I placed my stop there and got taken out when the price spiked up past that point. The price turned back down and I entered another short position at around 0.7530. Being a glutton for punishment I suppose, I put my new stop at 0.7580 which was just above the spike that had taken me out before. "No way it could happen twice in a row" I thought. Wrong. The price spiked up above 0.7580, took me out and then headed south again!

What could I have done instead? Knowing that the recent top would be an obvious spot for traders to place their stops, I should have avoided that area like the plague. There was a brief consolidation area further up in the 0.7620 area, and a less obvious and safer place for my stop would have been just above that. But then I would have been taking a much bigger risk and would have had to reduce my position size to compensate. Unless...unless I could somehow get a better entry!

That's where the idea of using the stop hunters to my advantage comes in. Knowing that everyone probably had their stops up at 0.7570 or so, and knowing how the stop hunters (sometimes) work, I could have made an educated guess that they would try to push the price up there to take out those stops. So instead of entering at the current market price of 0.7530, I could have placed an entry order at about 0.7570 and just waited patiently for the stop hunters to accommodate me by pushing the price up there. Then I could be entering the trade on the short side at 0.7570 along with the knowledgeable heavy hitters instead of being taken out of my position at that point along with all the sheep.

The key to this is having the patience to wait for the better entry. There are certainly some variations on this trading tactic too. If you're not sure that stop hunters will try to push the price to your hoped for entry point (or if you're not sure that stop hunters exist at all), you might want to enter part of your trade at the current price, and place an order for part of it at the better entry price. That way, if the stop hunters don't accommodate your clever plan of taking advantage of them, you will still be in the trade for a smaller amount. This also compensates for the fact that your stop is further away.

Conclusion
So to summarize:

1. Pick your stop location first, then base your position size on that, not the other way around.

2. To find a good place for a stop, pretend that you're considering a trade in the direction of the stop. Where would the price have to be to convince you that it was really moving in that direction?

3. Don't put your stop in obvious places like just behind highs and lows, just beyond obvious support/resistance levels, or at nice round numbers.

4. Use stop hunting activity to your advantage by placing your entry order near where you think most people have placed their stops.

I hope this helps you place better stop orders and avoid getting taken out of the market so often, especially when you're right about the trade direction. Maybe those of you out there who have sworn off using stops in the FOREX market will reconsider as well. Good trading to you!

You need to be logged in to post comments or rate this article.

I am new to Forex trading. So I find the idea of first locating the stop, then calculate my position size (based on the amount I can afford to lose) a fantastically logical method.
This is the first time I have come across this idea after my 3 months' study of other methodologies.
I also like your idea of working with the stop hunters. Quite wicked... :)

Feb 28, 2009

Newbie (1 post)

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