In a field where many praise continuous movement, many forget that pushing back is also a strategy. As a trader, your capital is your most valued asset and once it’s gone, it’s never coming back. Thankfully, there are ways to cut your losses and protect your profits. With the right strategy, a Stop Loss can even save your capital for your next investment.
As the name suggests, a stop loss is an order that limits your potential losses from trade and protects the pips from returning to the market. However, while a stop loss is designed to help keep pips in check, many traders do not know how to set a proper one, leading to an ungraceful early exit.
While there are other strategies employed in setting stop losses, let’s discuss three fool-proof approaches to setting a proper stop loss: fixed-based, trend-based and volatility-based.
The simplest way to set a stop loss is to do a fixed-based stop loss. It’s a stop loss order with set previous we start entering the position based on our money management calculation. For example, when we do some analysis, we know based on the Price Action strategy that we have a level that we want to set as the stop loss level, then we enter based on that level to create a better Risk and Reward trade. So we set the Stop Loss already in that level, then we just let the trade goes, on some certain level we may close our trade manually when we got the profit, or the trade hit the Target Profit level, or after certain movement, we can move the Stop Loss to the Entry Price.
In a trend-based stop loss, the order is placed at a level that invalidates the current trading set-up. For instance, in an uptrend market, you can identify three points: the lowest, the middle, and the highest downtrend. Using a trend-based approach, a stop loss order may be set on the lowest downtrend for optimal loss cutback, as the price is relatively low compared to that of the highest point. In this approach, identifying where the set-up may fail can help you exit before a bigger loss appears.
A volatility-based stop loss, on the other hand, uses a technical analysis indicator called the Average True Range (ATR). Using this approach, the stop loss order is set at an ATR beyond the area of value, which involves two variables: the current ATR value and the swing low value (lowest price point). The current ATR value is simply deducted from the swing low value, resulting in the stop loss level at which you can set your stop loss order.
Pro tip: ATRs can be adjusted in multiples based on your trading set-up. Setting a narrow stop loss widens your position size but puts you at risk of a premature stop-up, whereas setting a wider stop loss may narrow your position size but gives you relatively more stability in controlling your movements.
During a particular time when there is low volatility in the market, many traders use stop hunting as a strategy to open trading opportunities. Stop hunting is a strategy that forces traders to exit by purposely triggering stop loss orders, creating a high-volatility market, and presenting unique short-term trading opportunities which may be profitable for some traders.
For traders holding long-term positions, stop hunting causes continuous losses. In this case, setting the stop loss order at a definite level below support and above resistance can help avoid the occurrence of stop hunting.
At the end of the day, a loss is still a loss. However, a small loss is a hundred times better than a burned capital. While it’s true that you can be stopped up from time to time, stop-loss orders not only can protect your capital and your profits, but can also give you time to reevaluate your trading setup to minimize even more losses than that afforded by a stop-loss order.