Your Portfolios's Saving Grace: Your Step-by-Step Guide to Setting Your Stop-Loss

Posted 06/05/2009, 9:00 am EST by Sean Hyman from worldcurrencywatch.com

In my experience as both a Forex instructor and trader, I’ve found that currency beginners also have trouble placing stop-losses (aka “stops”) on their accounts. Newbie investors either think they don’t need stop-losses (BIG MISTAKE), or they’re not sure where to place them.

So let’s clear up all these misconceptions right now, shall we?

First of all, yes stop-losses are vital for any Forex trade. Stop-losses are literally your portfolio’s saving grace. It’s your insurance policy to protect your account from volatility in the markets. In other words, it’s the only thing that can protect your earnings when the markets turn against you.

What’s a Stop-Loss Again?

A stop-loss is simply a mental or technical level in your trade where you automatically cash out your position to protect what’s left of your earnings. Usually, you use stop-losses to protect your account when a particular trade goes against you.

From a logistical standpoint: If you’re buying a particular currency pair, then you place the stop-loss below your entry level, because your protecting yourself just in case your pair drops in price.

If you’re selling-short a particular pair, you set stop-losses above the entry point, because you’re betting your pair will fall in price. If it rises instead of falls, then your stop-loss protects you.

Let me say again: You always want to place a stop-loss. If you don’t, it’s the same as risking 100% of your account balance on each and every trade. And guess what? If you continually risk 100% of your account on every trade, eventually one trade will wipe out your account (even the Forex pros pick a losing trade every once in a while).

So let’s talk about how to use stop-losses. There’s actually a handy tool you can use to know where exactly to place each stop.

Your Secret Weapon When Placing Stops

It’s called the ATR or the “average true range.” It’s a technical level on currency charts, and it’s my secret weapon for placing the most useful stop-losses on every single one of my trades. I recommend checking out the ATR for every pair before you actually place the trade.

It’s really not as complicated as it sounds. In short, the ATR tells you how volatile a currency pair is. Once you know how volatile a currency pair is, you can tell where to place your stop-loss.

EUR/USD Daily Chart

You see some currency pairs move more in a particular trading day than others. Some currency pairs have the potential to move 150 pips a day, while others can shoot up (or down) as much as 300 to 500 pips in a day. (Remember: Currency pairs move in “pips” the way stocks move in “points.”)

That’s a huge difference in a market where a movement of a fraction of a penny can earn you thousands. So you need to check out how volatile a pair is before you set your stop.

For the sake of argument, let’s say you did NOT heed my advice and always placed a 30 pip stop-loss on every single trade you made. (This means you instructed your Forex dealer to close the trade if it fell 30 pips below your entry price.)

This would probably work if you were trading pairs that only moved 100 pips a day. But as soon as you jumped into a currency pair that moved 300-500 pips a day, you’d probably wipe out your account.

You don’t want that. To avoid this, place the ATR on your daily, one-year chart to find out how much a specific currency pair moves. For instance, right now, you will find that the EUR/USD (euro/U.S. dollar) trades about 237 pips each day. However, GBP/JPY (pound/yen) trades about 451 pips a day…huge difference right?

So when you place your stop-loss, it needs to be twice as large for the GBP/JPY as the EUR/USD. Be sure to place your stops at least one to two ATRs away. For example, if the current ATR daily reading on EUR/USD is 283 pips, then a “two ATR stop” would be 566 pips away from the entry price.

Don’t Bother With Tight Stops – You Actually Won’t Make Money!

Next tip: Don’t place your stops too close to the price.

Some new investors are too scared of losing money so they place 5 or 10 pip stops on everything. That’s a bad idea, because your stop-loss will close out the position before you can make any money on the trade.

If you’re concerned about losing money, you want to put a wide stop on each pair, and then trade less. You can do this by trading fewer lots. This is ultimately a much better idea than trading a bunch of lots and putting a tight stop that doesn’t let you make any money on each trade.

This may sound boring, but honestly, you’d be surprised at how much money you can make over a year when you trade conservatively like this. By placing stops, and dialing down your risk, you’re actually increasing your odds.

Trust me, it helps a ton. This is how the pros think and operate. It’s the biggest difference between a pro and a typical retail trader - risk management.

This is How I Made 100% in Four Months

Just to prove this point to a buddy of mine, I opened up a micro-account (which is 1/10th the size of 1 mini-lot). Most traders don’t even bother with micro-accounts because they trade such a small amount.

Using this strategy, I traded 1-3 micro lots (1/10th to 1/3rd of 1 mini-lot) for some months. I placed my stops at 200 pips wide typically. Within four months, I was up over 100% in the account with tiny moves and risk management.

Now my buddy is a believer in risk management too.

To recap: Stop-losses are important. Use the ATR to find out how volatile a currency pair is so you can set your stop accordingly. And don’t set your stops too close to the price or you won’t make any money in the long run. Instead, trade less and set wider stops.

Do that and you will be surprised at what your account balance looks like just one year from now.