Let me ask you:
Do you get stopped out of your trades only to watch the markets reverse back in your direction?
Or perhaps you try to ride a trend only to get stopped out on the retracement.
And you’re feeling…
“Argh, the market is rigged!”
Well, that’s because you put your stop loss at the same level as everyone else — and it makes you an easy target for a stop hunt.
But don’t worry, all this will change.
Because in this post, you’ll learn you’ll learn how to set a proper stop loss so you can reduce risk, maximize profits, and avoid stop hunting.
Then continue reading…
Why using a stop loss order is your greatest trading tool
A stop loss order gets your out of a trade when it goes against you.
You long Apple shares at $100 and place a stop-loss at $90. This means that if Apple trade to a low of $90, you will exit your trade immediately, restricting your loss to $10 (assuming no slippage).
And not only that…
The benefits of having a stop loss include:
- Preventing you from blowing up your trading account
- Limiting your losses
- Living to “fight” another day
You can treat stop loss like an insurance. You dislike paying the small premiums, but you’re glad you have it when sh*t hits the fence.
This is what I mean:
And here’s what happens next…
If you can’t take a small loss, sooner or later you will take the mother of all losses. – Ed Seykota
You know the importance of having a stop loss. Let’s learn how you can set a proper stop loss.
How to set stop loss to reduce risk
I’m going to share with you 3 ways to do it:
- Volatility stop
- Time stop
- Structure stop
A volatility stop takes into account the volatility of the market.
An indicator that measure volatility is the Average True Range (ATR), which can help set your stop loss.
You need to identify the current ATR value and multiply it by a factor of your choice. 2ATR, 3ATR, 4ATR etc.
In the example above, the ATR is 71 pips.
So if you were to place a stop loss of 2ATR, take 2*71 = 142 pips
Your stop loss is 142 pips from your entry.
- Your stop loss is based on the volatility of the market
- An objective way to define how much “buffer” you need from your entry
- It is a lagging indicator because it is based on past prices
A time stop determines when you exit your trades based on time.
Instead of exiting your trades based on price, you exit your trades after X amount of time has passed.
You need to define how much time you will allow before exiting it.
You took a short trade at resistance area. But after 5 days it’s not going anywhere, so you exit your trade.
- You reduce losses
- If you have trading records, you can identify optimal amount of time to give your trades
- You may exit prematurely only to see price move in your favor
A structure stop takes into account the structure of the market and set your stop loss accordingly.
Support is an area where price may potentially trade higher from. In other words, it’s a “barrier” that prevents further price decline.
Thus, it makes sense to have your stop loss below Support. Vice versa for Resistance.
Here’s what I mean:
You want to place your stop loss where there is a structure in the market that can act as a “barrier” for you.
Below is a training video that explains this concept in more detail…
- You know exactly when you’re wrong because the market structure has broken
- You’re using “barriers” in the market to prevent price from hitting your stops
- You need wider stop loss if the structure of the market is large (this results in small position size to keep your risk constant)
You’ve just learned 3 new ways to set your initial stop loss.
How do I trail my profits as price goes in my favor?
How to set trailing stop loss order to maximize your profits
A trailing stop loss will maximize your profits and let you ride massive trends. But at the expense of a lower winning rate.
If this is something for you, here’s 6 ways to do it:
- Structure break
- Moving average close
- Moving average crossover
- X period high/lows
- Average true range from peak to trough
You know an uptrend consists of higher highs and lows.
You can use it to trail your stop loss below the previous swing low, till it gets broken.
In a downtrend, you can use it to trail your stop loss above the previous swing high, till it gets broken.
Something like this…
This works best when price action is clean, with obvious swing highs and lows.
If price action isn’t too clean, this is when moving averages could help…
I get a lot of questions by traders asking me, Rayner, which is the best moving average?
The truth is, there is no best-moving average.
You need to understand they’re simply tools to help with your trading.
So which moving average do I use?
You can consider using:
- 20ma if you want to ride short-term trend
- 100ma if you want to ride medium-term trend
- 200ma if you want to ride long-term trend
Here’re a few examples…
Or, you can use a moving average crossover to exit your trades.
Moving average crossover
You would use a faster-moving average against a slower moving average.
If a faster moving average cuts below the slower moving average, you exit your long position.
If a faster moving average cuts above the slower moving average, you exit your short position.
There’re endless permutations here, but for illustration purposes, I’m using 5ma & 20ma.
As shown below:
Moving average is useful when the price has an ebb and flow to it.
However, if the price goes parabolic, the moving average will lag the market, and risk giving back a chunk of profits.
This is when you should consider trailing with…
X periods high/lows
X here is defined by you. You can use 1,2,3 etc.
If X is 1, you will trail below the previous day low.
If X is 2, you will trail below the previous 2 day low.
You get the idea.
When the price goes parabolic, this is when trailing your stop loss with X periods high/lows can be useful.
Price is parabolic when you notice the range of the bars getting larger in the direction of the trend, and the angle is getting steeper.
This is what I mean:
Parabolic moves can be subjective. One way you can determine is to use trend line, here’s how…
A trend line helps identify the trend in the market by connecting the highs/lows.
But when you start to re-draw your trend line because the trend is getting steeper, chances are, you’re in a parabolic move.
And when price breaks the recent trend line, you can look to exit your trade.
This is what I mean:
Here is a trade taken by Dan Zanger, that explains further:
The techniques taught earlier requires an element of discretion.
If you’re someone who prefers to exit their trades systematically, then the next technique may interest you.
Average true range (ATR) from peak to trough
This approach is used by systematic Trend Followers who exit their trades based on price moving X ATR away from their peak/trough.
X can be multiple of 1,2,3 etc.
If X is 1, then your stop loss is 1 ATR away from the peak.
If X is 2, then your stop loss is 2 ATR away from the peak.
You get the point.
In his book, Following the Trend, Andreas Clenow uses 3 ATR away from the peak to trail his stop loss.
Here’s an example:
This approach would suit you if you’re trading systematically.
You’ve learned 6 ways to trail your stop loss for maximum profits.
You’re probably wondering…
What if I don’t want to trail my stop loss, can I have a fixed target profit instead?
Yes, you can.
And this is what you’ll learn next…
How to set a profit target to improve your trading consistency
By having a profit target, you will increase your winning rate, but at the expense of lower profitability.
If this is something for you, here’s 3 ways you can do it:
- Support & Resistance
- RSI indicator
- Fibonacci extension
Support & Resistance
You’re long, where would seller come in?
You’re short, where would buyers come in?
Here’s a clue…
Support is an area where there is potential buying pressure to push the price higher.
Resistance is an area where there is potential selling pressure to push price lower.
This means if you’re long, it would be prudent to take profits at the nearest resistance.
And if you’re short, it would be prudent to take profits at the nearest support.
You can use RSI indicator to identify overbought and oversold areas (above 70 for overbought, below 30 for oversold). This can also act as Support & Resistance in the markets.
I’ve learned this technique from Steve Burns, in his book, Moving Average 101.
Here’s an example:
This approach works well when the market is in a range, or the trend is weak.
But what about trending markets?
This is when Fibonacci extension can be useful…
The more popular extension levels are the 127, 162 and 200.
Watch the video below to learn how to use Fibonacci extension to set your profit target.
You’re probably wondering:
Rayner, can I take half my position at a fixed target and let the remaining ride the trend?
Of course, and this is how you do it…
How to take partial profits and ride the trend?
In the book, The Art and Science of Technical Analysis, Adam Grimes explains how he exits part off his position at 1:1 risk reward, and let the remaining position ride.
This helps improve his trading consistency and gives him a smoother equity curve.
Here’s how you can do it:
- Take profit at the nearest Support & resistance
- Trail the remaining position using a trailing stop loss (like moving average)
It looks something like this…
- Improves your trading consistency
- Opportunity to ride a trend
- Easier on the psychology as you’ve banked some profits
- Lower profitability as you exit partial position
There are many ways you can exit your trades and there’s no right or wrong.
If you’re a trader who’s looking for trading consistency, then taking partial profits would suit you.
If you’re a trader who’s looking to increase his net profitability, then riding the trend with full position size would make sense.
Blindly following another trader’s strategy isn’t going to work in the long run. Ultimately, you need to find an approach that suits your personality, beliefs about the market, and your trading goals.
Now, here’s what I like to know…
How do you set your stop loss in trading?
Leave a comment below and let me know your thoughts…