“Whenever I enter a position, I have a predetermined stop. That is the only way I can sleep. I know when I am getting out before I get in” – Bruce Kovner, Market Wizard
Have you ever had your stop hit at what turned out to be the low? Was it just bad luck? Or is there something more at play?
The chances are there actually is.
Forex trading is a zero sum game. One person’s loss is another person’s win. You can bet that the strong players with more information, more money, and the ability to move the market, are out to get as much easy profit as they can. This means that the retail players left holding the weak hand (i.e. with stop-losses) had better watch out.
But the dealers can be beat.
By sidestepping traps and learning how to place your stop-loss in places that are difficult to hit, you could add significantly to your trading bottom line.
The first step is to understand dealing ranges…
How dealing ranges influence the price
“The most important thing is to have a method of staying with your winners and getting rid of your losers” – Gary Beilfeldt, Market Wizard
Dealing ranges drive market behaviour.
A dealing range is simply a high and a low for a trading session or a time period, such as day, week or month. Dealers use these levels to work out their orders and manage their positions.
You can see examples of dealing ranges on the 15-minute chart of the EUR/USD here:
Dealing ranges exist on multiple timeframes. You can see the dealing ranges here on the 4-hour chart:
Dealing ranges are imprecise. The edges of the range are often pierced, and the levels the dealers use for reference are fluid.
You will notice that an old dealing range will often form the basis for a new dealing range; i.e. they act as support and resistance levels. This is a type of market structure that is tradable and can provide you with an edge.
In the following chart you can see old ranges are used as reference points for new ranges.
Traders who are taught to put their stops behind support and resistance levels will often put their stop-loss orders behind dealing ranges. But the problem for these traders is that their stops then become a target for those that want to be on the other side of the trade at that price. This is true of any major level.
You can see this quite clearly on most Forex charts.
On the following chart, I have marked with red dots where a move has taken out stops before reversing above or below either the dealing range or a support and resistance level.
You can see how often your stops would be taken out if you were not careful about your entry or where your stop-loss was placed.
So the solution is simple, right?
Widen your stops, and don’t put them so close to the edge of the dealing range…?
Not so. There are other factors to consider first.
Tight stops improve the risk-to-reward ratio of your trades
“I am wrong all the time. If I can be right 60% of the time, and when I am right I have some big winners, and when I am wrong, I staunch the losses quickly, I can make a lot of money” – Martin Taylor, Market Wizard
There is a problem with widening your stops. A wider stop means that when you do lose, you lose more. Also, consider that you may decide to trade less in total, to compensate for a wider stop. In this case, your winners would win you less.
Both of these factors will have a negative impact on the risk/reward ratio of your trades. When you do win, you will make less compared to your losses than if you had a tighter stop. On the flipside of the coin, it could mean that you will have more winning trades to compensate for the smaller wins. By widening your stop, your win percentage improves.
Wide stops can improve the quality of your system
“Place your stops at a point that, if reached, will reasonably indicate that the trade is wrong, not at a point determined primarily by the maximum dollar amount you are willing to lose” -Bruce Kovner
If you have a wide stop you will in general:
- Improve your winning percentage
- Increase your flexibility when managing your trade
If your stop is further from the market, it gives you more latitude on your entry. If you get the general direction right, but not the exact timing, a wide stop will allow the market to move against you a little before settling in your general direction. This means that you will, on average, have more winning trades than if you have a tight stop.
In addition, if your stop is wider, you will have more opportunity to manage your trade and get out with a loss that is smaller than 1R. For example you might experience a reversal right on entry and chose to get out with a small 0.2R loss. If you stop-loss was tighter, then you might have ended up with a 0.5R loss or even a 1R loss.
For the savvy trader, having more winning trades and losses that are smaller than 1R could significantly increase the quality of their trading system. If you have a higher quality trading system, then your position-sizing model can allow you to trade at a larger size, somewhat compensating for the decreased risk/reward ratio on your trade.
The downside of a wider stop-loss is the decreased risk/reward ratio. But this is not always true. See how you can have a wide stop and still have an excellent risk/reward ratio on your trades.
Stop-losses are inextricably linked to your entry strategy and trade objectives
“I have a mental stop. If it hits that number I am out no matter what” – Paul Tudor Jones, Market Wizard
For example, if you are a trend follower looking to catch a breakout, you might have a tight stop-loss that you expect to get hit more often than not. Or if your goal were to have a 3:1 risk/reward ratio on your trade, you would have a tighter stop than if you were going for 1:1.
Logically choose a stop that fits holistically into your trading strategy.
Psychology and stop-losses
Losses can be difficult to take, as traders like to be “right”, and would prefer to avoid taking losses.
The trick is not to associate loss with failure. Instead, it’s important to see a loss as a “cost of doing business”. I.e. the results of any one trade don’t matter. Rather, it is the distribution of outcomes over a series of trades that matters. In other words, you will win some and lose some, and it is what you end up with over time that is important, not the results of any individual trade. Some traders find it helpful to think of trading as a “game”.
Another psychological challenge with stop-losses is that the more losses you have in a row, the less confidence you will have in your system. The next trade after a big loser will be more difficult to take, even if you know over the long run that your system performs profitably.
When you develop your stop-loss strategy, you need to consider your ability to continue to execute your system even after a series of losses. If your stop-losses are too tight then, even if you do have the occasional big winning trade, you might find it challenging to continue to execute in the face of a series of losses.
Market types and stop-losses
As the market types shift and change, so should your approach to the market.
This goes for stop-losses too.
Consider whether your stop-loss placement is suited to the current market type. In addition, be prepared to change your strategy for your stop-loss if the market type changes during a trade.
A note on volatile market types
Common wisdom espouses that during a volatile market type, you should widen your stop-loss. I am of a different opinion. If the market type becomes volatile, you want to tighten your stop-loss. The markets have just gotten a whole lot more hairy, and you don’t want to give the market room to move against you. You will need to prepare to be stopped out more often in this market type. However, by having tight stops, you will have the opportunity for some quick profits when things do go your way.
Superior options for stop-loss placement
“When I am wrong the only instinct I have is to get out” – Michael Platt, Market Wizard
You main considerations for stop-loss placement:
- The dealing ranges
- The risk/reward ratio
- Your entry and trade objectives
- The market type
- When your idea is proven wrong.
Understanding this, here are some different strategies for placing stops that can help to improve the profitability of your trades.
Classic support and resistance stop-loss
The classic place for Forex traders to place stops is behind support and resistance levels. Just be aware of the stop-hunting intentions of those participants who can move the market. You could put your stop 10-25 pips or 0.25-0.5% beyond the level, which will help you to avoid some of the whipsaws, but remember this will impact the risk/reward on the trade.
This is perhaps a smarter way to place your stop-loss.
Wait until after the stops have been hunted and the price has reversed before you enter. Then place your stop-loss either directly behind the support or resistance level – or even slightly inside it – to improve the risk/reward on the trade.
On the following chart, you can see how once the stops have been taken out (the thin red line), it is safe to place your own stop-loss (the thick red line).
Indicator stop-losses can be quite useful for three reasons:
- They give you a consistent place to put your stop that requires little discretion
- They are (or should be!) relevant to your entry and trade objectives
- The stop will not be in the usual place that other market participants will be targeting
For example, you could put your stop-loss on the blue (100 period) moving average on the 15-minute chart of the USD/JPY when you enter short on this moving average crossover strategy.
The “mid-air” stop-loss
To avoid being “stop-hunted”, a mid-air stop is just the ticket. Mid-air stops are set far enough away from the edge of the range to make it difficult for it to be hit. In addition, as your stop is likely to be on its own and not grouped with a bunch of others, there will be little point in others going for it anyway.
Mid-air stops work best when trading directly off support and resistance levels. You simply place your stop far enough away from the dealing range that it will look like it is hanging in mid-air, away from the action.
A special note on breakeven stops
“Getting out sometimes right before the [currency pair] turns is the price you pay to keep your losses under control” – Joe Vidich, Market Wizard
There are both pros and cons for breakeven stops. Only you will know what is right for you.
On the one hand, a breakeven stop is a powerful psychological tool. It ensures your winning trades don’t turn into losing ones. This means that your winning percentage will increase, which can make it psychologically easier to follow your system and trade mistake-free.
On the other hand, if you move your stop-loss to breakeven, you may end up putting your stop in an illogical place that the dealers can easily go for. In my experience, this can mean that although you have less losing trades, you will actually make less overall. The winning trades that you do miss out on will reduce the profitability of your system over time.
That means you are faced with a choice. Which is more important to you?
- Consistency; or
So what to do next?
“Simplicity is the ultimate sophistication” – Leonardo da Vinci
Now, it becomes a simple matter of testing. Try adjusting the following combination to see what suits your system:
- The risk/reward ratio by tightening and widening stops
- The stop-loss method.
Always think about the dealing ranges. Keep in mind where the market is likely to move to next, and avoid putting your stop in places that are easy to hit. Remember, your loss is their gain.
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Until next week,
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