Think Like A Trader Blog

Thursday, 19 April 2018

Stop Losses When Trading - Different Types and Considerations




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Stops. Every trader needs them, and if you don’t have one in place, you are asking for trouble. The market will eventually reach out from the computer screen and give you a less than friendly slap, and the stinging wont only be in your face, but your trading account. A stop takes you out for an acceptable loss when the trade moves against you and at a point where you have decided that it is best to walk away and lick your proverbial wounds.

But what is in a stop? Every trader knows they should use one, but very few actually consider the type that will suit them.

I am going to cover three in this blog –

- A small fixed number stop
- A stop that adjusts to recent market volatility
- A structure-based stop


Small Fixed Number Stop

This stop tends to be placed above or below the signal candle by a certain number of pips. It will vary depending on the market you are trading and also the timeframe, however for this example we will say you use a 5 pip stop above or below your signal candle.

You use the same stop for every position you take, and the overall stop size comes down to the size of your signal candle. This stop does take into account the market volatility somewhat, since it is based around the signal candle, however it does not give a lot of room for market movements once in the trade.


Benefits

- Your stop is easy to work out. You can do it quickly before entering a trade. There is no uncertainty, since you know exactly what size the stop will be.

- This type of stop tends to be better for risk reward ratios. The smaller the stop, the less the market must move for you to get to a good level or risk reward.

Drawbacks

- Because the stop is relatively tight to the candle, you will suffer a higher portion of losses than say using a structure stop.

- It does not give the market a lot of room for normal price movements before it hits your stop. You will find that on certain trades, you are stopped out and then the market moves to your intended target.

Stop That Adjusts to Recent Market Volatility

This type of stop takes into account recent price movements. It means your stop will expand as the market gains in volatility and reduce as the market quietens down. There are a number of ways to set this stop, however one of the easiest is to use the Average True Range. You simply add the Average True Range to your chart and set it to what you consider a range that will summarise the recent price action – I suggest 5 to 10 periods.

When using the ATR stop, it is also wise to ‘step-up’ timeframes to take the reading. If you are trading on the 1-hour timeframe, a reading of 5 hours isn’t really giving you a good view of what the market has been doing recently. But if you are on the 4-hour timeframe or daily, a 5-period reading takes into account a much larger market sample.

You then decide on your stop level from the reading. It may be 50% ATR, 30% ATR, 75% ATR or any percentage, depending on the type of trading you are doing.


Benefits

- As we mentioned, this takes into account the recent volatility of the market. This means that your stop will get larger as the market becomes more volatile, and smaller as it quietens down.

- You have a set stop size to use each day. It will also suit each market since the reading is taken off of that market.

- Less losses than a small number stop since it uses the market to determine size.

Drawbacks

- It is still an arbitrary number. Why a 30% stop instead of a 50% stop? Why not a 25% stop?

- If the market quietens down and then moves into a sudden period of high activity, your stop will not adjust quickly. Similarly, if the market has been very volatile and then quietens, your stop will still be large in relation to the market movements until the ATR catches up.

Structure Based Stop

I would say that this is the most common type of stop used by beginner traders. It is promoted on most forums and blogs as the only type of stop to use.

With this stop, you place the stop level above or below a recent level of structure, or ‘swing’. The idea being that if you are trading in a downtrend, you want to allow the market to chop around and it is only if it starts breaking above the previous swing-high that you want to exit the trade. If in an uptrend, you only want to be taken out if the market starts to break previous lows (hinting at the end of the downtrend). For reversals, you just pick a recent level of structure and place your stop above or below it.


Benefits

- You give the market much more room to move whilst in a trade.

- Less losses.

- You are using market structure to determine the stop loss level.

Drawbacks

- This stop tends to be a lot larger than the others. Because of this, gaining a good risk reward is harder and requires much larger price movements.

- It is very subjective. One ‘key’ piece of structure to one trader may not be the same to the next trader. Because of this, it can become difficult to determine where to put the stop.


So, there we have three different style of stop. You will notice that they all have benefits and drawbacks. The truth is, with trading, it comes down to the individual trader and their trading plan. I never advise that you just pick a random stop and stick with it. You should test lots of different style stops and also sizes of stops. Let’s say you use a structure stop and need a 1:3 risk reward ratio to become profitable with your trading plan, but your trading plan only produces on average 1:2 risk reward trades using the structure stop. It won’t work and it doesn’t matter how ‘well’ you are trading.

Now let’s say you test your methods again and this time you use a much tighter fixed number stop. You realise that using this stop you suffer more losses, but now you can get lots of trades at 1:4 and 1:5 risk reward. Suddenly your trading becomes profitable.

Most people do not like putting in the work, especially when it comes to testing and refining their trading plan. They settle on something they stumble across and then wonder why they are doing so badly. You MUST be willing to try things that may not at first strike you as beneficial.

Do what others aren’t willing to do so you can achieve what others will never achieve.

I hope you’ve all had a great trading week!

James Orr

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