Strategies for Stop Losses and Profit Limits by Abe Cofnas

Strategies for Stop Losses and Profit Limits by Abe Cofnas

One of the most common mistakes of new traders is being stopped out.  The market seems to know where your stops are and takes those stops and then, adding insult to injury, returns in the direction originally projected by the trader!   How can this be avoided?  Where should stops be placed for optimal effectiveness?

One of the most common mistakes of new traders is being stopped out.  The market seems to know where your stops are and takes those stops and then, adding insult to injury, returns in the direction originally projected by the trader!   How can this be avoided?  Where should stops be placed for optimal effectiveness?

The best approach to stop losses is to use them to get out of a trade when it is no longer justified.   If one is buying then a sell stop should be placed where the next sell signal would occur.  If one is selling then a buy stop would be placed when the market reverses to justify entering a new buy order.  To find the location for the stop loss, based on this strategy, ask yourself where would you be placing the opposite trade?

As in all other aspects of forex trading, there is more than one dimension to an answer.  If the technical location for a stop loss order is where the price action causes one to do the opposite trade, then what happens if the location is too far away from the entry?   One answer is not to do the trade. If the technical location for a stop means too much risk then the trade is not a good trade.   

Notice that we have not mentioned a gain/loss ratio.  If the trade holds a high probability of a win of 40 PIP’s and the best location for a stop is 40 PIP’s, the resulting win/risk ratio is  1:1.  Is that acceptable?   Would it be better to have a WIN/RISK ratio of 3:1 where the trader is going for 120 PIP’s and risking 40 PIP’s?   Before you answer the question, ask yourself, how do you know that the win will be there?  You cannot control the amount of PIP’s you can gain in a winning trade. You can control the risk. 

An arbitrary amount of PIP’s for a stop can be in direct conflict with the technical situation.   

Using risk management strategies of risk control based on exposure to loss helps out. If each trade risks 2% of the equity and a trader has $5000 in the account, the risk tolerance level is $100 or 10 PIP’s on the average.  This level is very small and will almost guarantee being stopped out.   If the trader raises the risk to 4% then more tradable situations will arise. The reality is that from a money management point of view about 12 trades in a row that are losses would result in ½ of the account value drawn down.  

Ultimately there is a balancing act between risk exposure and technical requirements.

It is always there. The answer is to maximize the probability of winning by entering trades that have the highest level of confidence.  

Note: Please see Abe’s book “Understanding Forex: Trading to Win” for the remainder of the chapter. Copies can be obtained from the Freebie section of forexhound.com
Other topics covered in this chapter include:
  • Strategies For Trailing Stops

  • Setting Limits