A very basic tool that is used for trading is the Stop Loss (SL)
It’s something I was taught a long time ago to use and take it for granted that everyone else would do the same thing.
But it’s surprising how many don’t…
The Stop Loss is an ESSENTIAL tool to use on EVERY trade.
Simply because it prevents too much loss when the trade goes against our expectation.
Lets use the chart below as an example to show why we use a Stop Loss…
This is the EURUSD chart at the time of writing.
We consider placing a trade to go LONG and we BUY on EURUSD. (Blue arrow is the expected direction.)
Now, we are either right or wrong. We either make or lose money.
Going long, the price can go as high as it likes, it has no limitations! Great for us!
If we are wrong, then it goes against us, and it’s only limitation is when it hits the floor at zero, taking a whole load of our money away with us.
It’s not likely to go this low, but it could plummet on some news events.
We would likely manually close our trade when we see enough of a loss that we cannot stomach any further…
But it may plummet when we are not motoring the charts, maybe bed time or between our chosen trading times.
So we use a Stop Loss to protect our losses and keep them small.
Remember, lots of small losses and few huge wins is the likely outcome in trading. The huge wins outweigh the small losses. But the losses are only kept small if you ensure it by using a Stop Loss.
Stop loss levels are available in every trading platform… as far as I know.
When you open a trade, place a stop loss too.
Now, with this stop loss, I still have my unlimited long movement but if it turns against me, the price will only fall so far before the stop loss automatically closes my trade, minimising my losses.
I really cannot see any reason for NOT using a stop loss in your trade.
Choosing where to put your stop loss is another difficult decision.
How about we move it closer to the BUY line so we keep our losses even smaller?
Well, the price bounces around, and it can go against us before going in our favour. This means it could go against us a little bit and stop us out before going right where we wanted it to go…
See the potential in the chart below.
If we placed our stop loss (red line) too close to our entry point, we see that the price turned against us a little bit and then went in the direction we wanted.
Price action is never straightforward. It bounces around as you can see in any chart.
In this case it bounced to our stop loss where our trad would automatically be closed for a small loss.
A good place to choose a stop loss level is below the most recent lows of the chart.
Another tool I use is to add a “Donchian Channel” indicator (available in most platforms) with a 40 period average setting. What this does is plots a line of the average of all the lows of the last 40 bars.
I then place the stop loss just below the donchian channel plotted line.
I also use this to then adjust the stop loss as the price moves in my favour… but I’ll explain that another time.
By giving this “wide birth” we allow the price to bounce around (as it will do anyway) before heading in our expected direction, without closing our trade but still having that safety net.
If we still reach our Stop Loss, then we were most definitely wrong about the price direction and we have been saved before we see a large loss!
It’s very rare, in any of my testing, that a Stop Loss is actually hit. The system I use will give me a “close trade” whether that is in profit or not.
The close trade signal will often appear way before the Stop Loss level. Keeping our losses at an even more minimal level.
However, if for some reason I cannot get to my computer and I miss these “close trade” signals, the stop loss will protect me should the price continue to go against me.
Sometimes, large “spikes” or a huge move appear in the charts meaning something drastic may have happened. Without a stop loss we could stand to lose a huge portion of our account balance.
See this example found on LuckScout.com
I hope you found this useful and for those who didn’t use or understand what a stop loss was, that you will definitely use it from now on!
Any questions, just ask away!
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