Stop Losses: Always Use a Stop-Loss Order to Limit Your Risk

There are two types of traders. Those who use stop loss orders and those who are about to be hurt in the market.

When trading a position that technically has an unlimited loss potential (e.g. a spot currency position or a futures contract) you must always use a stop-loss order.

It works like this:

Place your order e.g. sell US$100,000 (remember because you can trade on margin you only have to put up $3,000-$3,500 to do this) against the Japanese Yen at the current rate, say 106.00.

Pick a dollar amount that is the maximum you would be willing to lose if you got it wrong i.e. the US Dollar strengthening against the Yen instead of weakening. Let’s assume that amount is US$1,500 (for calculating risk percentages see www.TradingBook.org/risk).

Using a spreadsheet work out where exactly the exchange rate would have to move to, to result in a US$1,500 loss. The spreadsheet formula looks like this:

= ((100,000*106)/(100,000-1500))
= 107.61 (rounded)

Place your stop loss order at 107.61.

This means that if you get it wrong (and you will), once the rate goes to 107.61 you will automatically be sold out of your position limiting your loss to $1,500. Note that neither you nor your broker needs to be watching the rate or even be awake! Your order is computer generated and will trigger automatically.

Whenever you enter a trade, always accompany it with a stop loss order. If you take this advice you will avoid large, unexpected losses.

I have talked to a lot of traders who started out trading without stop loss orders. Without exception they all take a large and surprising loss in the market and finally start using stop loss orders.

Trailing Stop-Losses

In addition, you can use stop loss orders that you move up as the price moves up or down as the price moves down. These are called trailing stop-losses.

Using our US Dollar versus Yen example. If you sell US$100,000 against Yen at 106 and two weeks later the rate is 101.44 your profit will be $4,500. Firstly you don’t want to sell at this level because if the market keeps moving (trending) you will make more. But secondly you don’t want to risk losing all of the profits you have already made. The way to accomplish both of these is to move your stop loss order.

Cancel your original stop loss order at 107.61 and place a new stop loss order at 102.91

If the market changes direction you automatically sell out at 102.91 giving you a profit of $3,000.

But if the market moves down to say 100.00 you would cancel the stop loss at 102.91 and move the stop loss to say 101.50, locking in a profit of $4,435.

You keep doing this until the market changes direction. This way you maximize your gains. If you trade using an electronic trading platform you can program an exact trailing stop spacing (e.g. 150 points), and it will track it point for point.

NB You will never get out at the very top using this strategy but you never buy at the low or sell at the high. Be happy that you profitably traded the trend.

A Note on Retracements

When I am in a currency position that has performed very well and I am profitable by a few hundred points, I will do an analysis of the currency chart since the beginning of the move (and previous similar moves) to see what the retracement amounts have been. A retracement is a period during which the trend reverses in a small way but then the trend resumes.

For example if I was long USD Yen and I was onside by 350 points (3.5 Yen) I would look back to see when the trend started. Let’s say the trend started at 87.00 and the rate is currently 98.00. I would look at every major retracement in that time and make a note of the amount of each retracement. It might look like this:

First retracement:        3.26 Yen
Second retracement:        1.41 Yen
Third retracement:        2.67 Yen
Fourth retracement:        3.02 Yen
Fifth retracement:        1.89 Yen

Because I am very interested in staying with the trend and NOT being taken out by a normal retracement, I will generally set my stop loss beyond the range of the existing retracements.

Therefore because the current rate is 98.00 and I want a stop loss greater than 3.26 Yen (the largest retracement) I will put my trailing stop loss at say 3.3 Yen. My stop loss would then be 98.00 – 3.3 = 94.70.

IMPORTANT: Most traders will not allow such a big stop loss because they hate the thought of losing 330 points, especially if they have multiple positions. However those traders NEVER get to enjoy a move of 30 big figures (3000 points).

In 1997-98 for example USD Yen moved up 34 Yen (3,400 points). In order to have participated in the full move you would have had to have used a 5.5 Yen stop loss.

A Note on Moving Stops

We all hate taking a loss. We don’t want to crystallize the loss because then we have to accept it as a loss. As long as the trade is alive we can believe it will come back into profit and less us off the hook. Some traders even move their stop loss to make sure they do not have to cut their loss. NEVER move a stop loss level to allow a bigger loss. You are at your most clear-headed and most objective before you put on a trade. Once the trade is on you can become gripped with fear and you are no longer thinking rationally.

Conclusion

Always trade with stop loss orders working in the market. Never move a stop loss to allow a bigger loss. This will save you lots of money and lots of anxiety.

 

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