By Richard K.

Introduction to The Importance of Trading With Stop Loss Orders

Placing a stop loss order to protect yourself against the inherent risk that trading comes with, is a crucial part of trading and risk management. When beginner traders start out the importance of using a stop loss is generally highlighted in most educational material that they have read regarding risk management and include some important considerations as outlined below.

Stop Loss Orders – General Guidelines:

  1. Do not risk more than a certain percentage of your capital on any trade e.g. 1-2%
  2. Place a stop loss order below or above a previous important swing/pivot.
  3. Do not place your stop loss too close or you risk getting stopped out.
  4. Do not widen your stop loss after entering a trade.
  5. Allow the market enough space to move before limiting your risk e.g. trailing stops.

Although these sort of guidelines are typically very true, most of them cannot be adhered to properly without the use of a proper strategy that clearly addresses each of the above mentioned points, otherwise they remain pretty vague and leave the door open to many questions that ask how it should be done properly.

Most novice traders know that they should trade with a stop loss, yet many of them continue to trade without them or tend to widen their stop loss orders when a trade goes against them in the hope that price would eventually move in their intended direction.

Stop loss orders

An example of an event that illustrates the importance of a stop loss was when the USD/CHF currency pair experienced a “flash crash” of more than 18% in a few hours back in January 2015.  That particular event was unexpected and in many cases wiped out a lot of trading accounts, especially if they were leveraged too much.

In extreme cases like these some stop loss orders were not triggered due to the fact that price fell so fast that it either gapped below some stop loss orders or some of the traders were not at their screens watching that huge drop unfold until it was too late.

The best way to have prevented a catastrophic loss like that would have been to exit on market orders if your stop loss was not triggered and even then you probably would have lost money.

Professional traders are experts at managing their risk and when they are in a position that is profitable they do not simply sit back and relax under the assumption that nothing can go wrong.

The purpose of this article is not only to highlight the importance of using stop loss orders but to provide readers with examples of how to follow the previous mentioned guidelines in a systematic and effective way using a strategy.

How to Place a Stop Loss Order – Effectively

In this section of the article I decided to split the general stop loss guidelines into two parts. The first part will be dealing with the first four guidelines following my strategy and in part two I will cover how my strategy deals with the last guideline that has to do with managing my risk during an open trade that turned profitable.

Before we proceed, I would just like to give you a quick overview of what it is my strategy wants to achieve in the first place.

My strategy was developed to find the end of corrections within a trend and to enter positions once the main trend direction resumes again.

That may sound simple but there are many important steps that my strategy follows to break down the process of achieving that goal which includes the use of multi time frame analysis, market geometry, corrective pattern recognition, specific entry rules/conditions and open trade management.

In this article we will only focus on the subject of effective stop loss placement and management, but a link can be found in the conclusion of this article in case you want to know more about the entire strategy and its capabilities.

Part 1: Initial Stop Loss Placement

Using a recent trade example that resulted in a huge return on investment I will show you how my strategy followed the first four guidelines which were:

  1. Do not risk more than a certain percentage of your capital on any trade e.g. 1-2%
  2. Place a stop loss order below or above a previous important swing/pivot.
  3. Do not place your stop loss too close or you risk getting stopped out.
  4. Do not widen your stop loss orders after entering a trade.

stop loss

The chart above is that of the USD/CAD currency pair and on it I identified an area, or price zone, where I thought a corrective pattern could end. This was done ahead of time which allowed me enough time to prepare myself for an entry. I love using a market geometry tool called a pitchfork (blue and red lines on chart) and they work very well when hunting for the end of corrections.

how to place a stop loss order

One day later price touched down within my entry zone and reversed higher but what happened at that low (green arrow) is where my strategy allowed me to place my entry and stop loss order effectively.

Stop loss orders

Before I enter any trades I need to see a few conditions pop up on my 5 minute chart which I use as my entry time frame. These conditions stipulate that I see:

  1. Price entering my entry zone and interaction with my market geometry lines (red line on chart).
  2. There needs to be momentum divergence present at that area (blue MACD – Histogram).
  3. There needs to be a reversal candlestick formation or pattern (bullish flanked doji formation as indicated by the red ellipse).

Those 3 conditions is what signaled an entry for me and they always have to be present in order for me to execute any trade.

stop loss

With all my entry conditions present it was time to place my entry and stop loss order. I placed a buy stop order a few ticks/pips above the candlestick formation and my stop loss order a few ticks below that formation.

This is where the first 4 guidelines came into consideration:

  1. I knew where to place my stop loss ahead of time and I only risked 1% of my account equity on that trade. Some traders may risk a bit more but I was comfortable with 1%.
  2. I placed my stop loss below that reversal candlestick formation, which I considered to be a safe place to put it because it was below an area of market geometry (see red line on 30 minute chart) and I know out of experience that the red line would act as a strong area of support.
  3. With only a 12 tick stop loss many people may consider the stop I used, to be too close but considering all the entry condition and steps I had to go through to trade that setup the probability of being right on that trade was greatly increased.
  4. When I placed my stop loss I knew where to place it ahead of time but more importantly I accepted my initial risk and would never widen my stop in case price moves against me. This is where discipline becomes very important and I never move my stop unless it’s time to trail it to reduce my risk and lock in profits.

Part 2: Trailing Stops and Managing Open Positions

how to place a stop loss order

The last part of my strategy was designed to deal with guideline number 5, which allows price enough space to freely move around without getting stopped out prematurely while at the same time trailing my stop to lock in profit.

You will see on the chart above that I used my pitchfork lines again to show me the best possible areas where I can take partial profit while my final target was located a whopping 542 ticks higher (just below the upper red pitchfork line).

When I trail my stop I would only move my stop, for the first time, when price has reached my upward sloping center blue line of my pitchfork. I also took partial profit at that line (Target 1). Once price reached that center blue line I moved my stop to slightly above breakeven.

As soon as price reached my upper blue line (Target 2), I booked more profit and started trailing my stop loss more aggressively. You will notice that I trailed my stop loss below my pitchfork lines because they function as areas of support in case price moved against me.

When price came close to my final target I moved my stop to below the upper blue line of my pitchfork but in my case price eventually reached my final target and I was never stopped out.

Conclusion

Following some basic guidelines with regards to stop losses I use my strategy which has definite rules regarding stop loss placement and open order management so that I know exactly what my risk is beforehand and how to manage my risk while a trade is underway.

I have also learned to accept my risk before I take a trade because I have confidence in my strategy which often yields massive returns while only risking a fraction of my account. I will never trade without a stop loss and while a position remains open I will actively manage it because entering a trade is only a small part of the overall success of a decent strategy.

Managing an open trade properly without getting stopped out too quickly is just as important if you want to be a successful trader.

If you ever wondered what it takes to pull off trades that has such large profit potential on a consistent basis then be sure to visit my course info page here.

I hope that you fully understand the need for stop loss orders and now know how to place a stop loss order more effectively.

Until next time

All the best,

Richard K

 

Join the conversation! 3 Comments

  1. Great explanation on Stop Loss Management. I’m sure it is one of the keys to becoming a successful trader, of which I’m not “yet”. I really like Richard”s approach and am slowly learning the correct way to apply his advice and method in my own attempts at trading!

    Reply
  2. Many people say that the broker sees your stop losses, and it’ll bring the stock down to take you out, and run the stock after that.
    What’s your take on that?
    I feel that’s true because I get stopped out 90% of the time only to see the stocks rally without me.

    Reply

Leave a Reply

Your email address will not be published. Required fields are marked *

Category

Trading