We recently received an email from a client, stating his recent frustration:
I have been getting chopped up over the last two weeks and I’m in a Drawdown. The good news with that, is that I am not frustrated or bothered too much with the drawdown, but I am observing and thinking about what I can do differently.
What I am noticing is that there is not much follow through on breakouts and the break out of Asia is often faded quickly and the retracement significant before the trade resumes in the direction of the trend.  I ‘feel’ that the markets have changed recently and this ‘breakout failing’ is more noticeable to me.  Maybe Algos are creating this price action is thinner markets due to European holidays and lower volatility.  But that is a guess – it doesn’t really matter why. – I.K.
Before getting into the answer, we need to thank this trader for sharing his frustration and allowing us once again to bring fourth a blog post that – we hope – will help others that are experiencing the same issues.
The trader is getting stopped out frequently of late. Do not think we can avoid being stopped out – that’s just ridiculous. We are in the realm of uncertainty, and losses are the cost of doing business. You don’t need to like them or to accept them: just keep them as small as possible and as infrequent as possible.
Let’s analyze what has been happening to this trader, and what he can do to improve, going forward.

Background Check

Entries & stop losses are really just the tip of the iceberg. We need to verify that the trader is in fact selecting his battles wisely by trading evident trends. Fortunately this trader has been keeping good records of his trades, and has always been selecting quality background conditions which look something like this:

It is important to trade evident trends and avoid choppy markets like this:

So fortunately:

  • the trader has kept quality records that have allowed us to analyze and pinpoint his issues
  • the trader is not trading anything/anywhere: he is intercepting quality trends

but also

  • he remained consistent for a number of trades, until a clear pattern emerged. If you’re constantly changing tack, constantly adjusting your stance, it becomes quite difficult to understand when something is changing or requires improvement. Sam always reminds our workshop students to test 25-30 trades with the same rules, before drawing conclusions. By doing this you gain familiarity with the rules you’re using, with good behaviour and bad behaviour, and you become quicker at spotting changes in market dynamics that do require adjustments.

Foreground Check

The trader said that “breakouts are failing“. Since we haven’t noticed this ourselves, we had to investigate what the trader meant by “breakout”. Here is one of the trader’s “breakout” scenarios:

So in effect the trader is considering “breakout” just a plain Asia/Pacific session break. This kind of entry is fine, because it’s the last piece of the puzzle. We cannot control what the market will do, once we enter. We should also avoid putting our faith in the entry alone!  People typically waste too much time trying to perfect entries, when they might not even know how to select the right instrument or be trading a choppy market. So this trader is in a better situation in any case.

I’d like to simply remind the trader what a quality breakout looks like, typically:

The form is “boost – consolidation – boost”. There should be strong momentum leading into the consolidation, which gives a positive expectation for the subsequent boost.  The trader had identified a strong boost, but the Asian session wasn’t really in a tight consolidation, it was in a shallow retracement.

Tight Stops vs. Wide Stops

So the trader’s entries are “relaxed” and as such, we were expecting the stop placement to also incorporate a tad of “relaxation”. Instead the trader has been usually utilizing a “relaxed entry” with a “tight stop”. This was one of his better, more precise entries, so we’ll use it as a better example to highlight the point that the entry really is not the key.

The trader correctly noticed the retracement during Asia and entered on the break. His stop was logical and it was outside of the day’s action up to that point. However, the trader was stopped the next day. Could he have done something different?
I want all readers to stop for a moment and read these next words carefully: do not let hindsight blind you. You cannot approach trading by looking in the rear view mirror and say “if only I had moved my stop further away I would not have been stopped out”. You need to adjust your setups based on principles, not hindsight analysis.
So, with that out of the way, let’s talk about stop placement. In a nutshell:
Wider stops imply:
  • smaller position size
  • less activity
  • higher strike rate
  • more conservative equity curve

For example, the systematic CTA group (Dunn, Millburn, Acies, etc) utilize a very conservative stop loss strategy. They all basically size their positions so that 1 ATR = 0.20%. They do this because they do not believe in market timing and are purely in the trend-catching business. So whereas our trader has “relaxed” entries, he is still trying to time the market. The systematic CTAs basically don’t attempt to time the market.

Tighter stops imply:

  • larger position size
  • more activity
  • lower strike rate
  • more volatile equity curve

For example, from the entry on GbpCad to the day’s low was already approximately 1R worth of profit.

So how to select your stop loss placement? It depends on your time availability, your personality. and what amount of adverse excursion would be logical, given your objectives.  Given that most retail traders hate to lose, perhaps most would be better off by using a more conservative stop loss. Let’s see how we can establish logical places to put our stop loss.

In the example above, we need to ask ourselves: what adverse movement are we logically prepared to tolerate? What could the market do (potentially) that would put pressure on our trade but would not violate the overall bias of the market?

To do this, frequently all you need to do is look left. The market had broken below recent supports and a round number. Logically, the market may want to test the previous support. So a conservative stop would need to be just above the (now possible) resistance area.
But sometimes the tighter option and the wider option coincide. Let’s take yesterday’s GbpNzd suggestion we issued in the morning Cause & FX report:
We had suggested shorting around 1.7500 and the natural “tight” stop loss would have been just above the Asian high. Price would have to negotiate and break 1.7500 to the upside and then negotiate the Asian high, before stopping us out. Furthermore, the day would flip to positive.  So there’s already a lot of “adverse behaviour” required just to reach the tigher stop placement.
But even “looking left” we find that a previous support came in around the same place:
So in this case, a wide stop would have only diluted our position size and our foward potential. With the adequate stop, prices returned almost 2R into Friday’s close of business (40 pip stop vs. 80+ pip reward).

Over to You

The key takeaway is simple. Logical stop placement needs to take into consideration:

  • the nature of your entries (are you trying to time the market precisely, or are you just looking for an excuse to get in the trend?)
  • your time availability (the more time you can dedicate to the markets, the easier it is to time your entries more precisely and hence use tighter stops, and potentially re-enter if you get unseated prematurely)
  • your personality (if you’re a typical retail trader that has issues with losing, be more conservative with your stops and this should allow you to obtain higher hit rates at the expense of lower overall profitability; conversely, if you’re mature enough to deal with losses, then you can go down a more aggressive route)
  • what adverse market movement is logically possible

If you can utilize these basic principles to establish your stop loss placement, we believe your trading will never be the same, for the better.

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.