STRATEGIES FOR STOP LOSSES AND PROFIT LIMITS—ESSENTIAL COMPONENTS OF RISK CONTROL

Even if you mastered all of the elements of fundamental and technical analysis, trading
success would still require risk control. The most frequent question asked is: Where
should I put my stops? There is no definitive method for stops, but the most important
first step is to determine the risk per day that a person wants to tolerate. For example, if you have a $10,000 account, and the risk per day is 2 percent, this means that the trader
will tolerate a loss up to a limit of $200.
Any level of risk has the consequence of providing a boundary for the trading. Unless
you have an unlimited ATM machine to replenish your account, risk discipline is a critical
factor. The consequence of having $200 risk per day is that the trader needs to decide
how much risk a particular trade is worth. Is the next trade worth the entire risk of the
day? A $200 risk must also be translated into pips. Trading at standard size amounts
of $100,000, the value of each pip move is $10. This means that putting on a trade that
results in a 20-pip loss would result in using all of the risk for that day. The trader in this
situation would be foolish to risk a whole day’s trading capital on one trade unless it was
a fantastic setup. The trader should make room for several trades by choosing smaller
amounts to trade. Mini lots that involve putting on $10,000 would mean that the value of
a loss of 20 pips would be only $20. There is room for 10 more losing trades that day!
The concept of a risk per day can be better understood as having two accounts. The
first account is your real account with the capital in it. But the second account is the risk
capital account. Ask yourself how many pips you are willing to lose per day. By putting
on trades of $10,000 on a currency pair, many more trades can be taken. Yes, it does limit
the gains, but during the critical formative period where beginning traders are learning
trading, staying alive is more important than the magnitude of profits.
After selecting the level of risk per day, locating a stop loss becomes a choice of the
geometry of the price action. The first approximation for a stop loss location should be
the answer to where you would get out if the market moved against you. In other words,
if you were to buy a currency pair, then the stop loss would be where one would sell
it—and vice versa. The trader will look to the trend line and support and resistance lines
to find the location. But it’s not that simple in forex. Remember, there is noise in the
forex market. There is no precise location for the price, since it is a bid-ask market. One
of the most frequent sources of losses for beginning traders is being stopped out very
quickly. They place the stop close to the entry. In forex, the noise may take up three to
five pips easily.
The response to this situation is to allow the prices to vibrate through its range.
Here is where looking at larger time frames is important. You may trade off a 5-minute
chart, but remember the price pattern of the 5 minutes provides a close look. Zoom out
to the 15-minute and 30-minute charts to find more secure levels of resistance or support.
This translates into putting one’s stop loss above or below the 15-minute support
or resistance, or above or below the 30-minute support or resistance. If you’re trading
off a 4-hour chart, then day support or resistance is an appropriate level for locating
a stop.
Another method for finding an optimal location for a stop is the level of volatility.
Putting a stop above the extreme Bollinger band is one solution because that would
recognize that the price would have to go to new extremes to get stopped out.



Another tool for locating the stop is the average true range (ATR) indicator. The ATR
provides a measure of the “reaching” ability of the price in terms of its lows and highs.
Remember that the range is defined as the difference between support and resistance.
The ATR compares the range’s behavior to previous closes, highs, and lows. The ATR is
the greatest of the following three values:
1. The difference between the current maximum and minimum (high and low)
2. The difference between the previous closing price and the current maximum
3. The difference between the previous closing price and the current minimum
The ATR becomes a smoothing indicator of the true range over the periods selected.
How do we apply it to stops?
When the trader chooses to trade off a specific time interval, such as the 5-minute
chart, the range of that time interval is expected to be less than the range of the 15-minute
chart. Generally, the larger the time frame, the larger the distance between support and
resistance. By watching the ATR, the trader can get a sense of whether the candles themselves
are increasing in volatility.
Table 15.1 gives an example of two currency pairs and their associated ATRs for
different time periods. If the ATR with a period 14 indicates a level of 9 pips, let’s say
on a 15-minute chart, this means that the lows and highs could have been 9 pips higher
or lower on the average for the previous 15 candles. A good way to understand this is to
visualize any candle to stretch beyond its highs and lows 9 pips either way. So if the trader
places the stop near or at the ATR level, it is inviting being stopped out by the natural
tendency of the market to swing in the plus or minus 9 pip range around a candle. Here
is how to use this: A good rule of thumb is to use two times the ATR for your stop. If
one is trading on the 15-minute chart, then two times the ATR of the 15-minute candles
provides room to breath.
Alternatively, one can use the 30-minute ATR as the stop distance, even if one is
trading off the 5-minute or 15-minute chart. By doing so, the trader is acknowledging the
natural vibrations of the price. Try to test this application out by putting on two trades in
your simulation account. Place a stop on one of the trades based on your own selection criteria, but for the second lot, put the stop on two times the ATR of the 15-minute chart.
See how your frequency of being stopped out is reduced. In Table 15.1, we see that the
ATR of the British pound–U.S. dollar (GBPUSD) pair was 9 and that the ATR of the
euro–U.S. dollar (EURUSD) was 5. Using the rule of two times ATR, traders looking to
put on a trade in the GBPUSD would be sure to have a stop above 18 pips. Those looking
to trade the EURUSD could place the stop above 10 pips, since the ATR was lower in
value.
Very often, the question arises: Should the stop loss be a ratio of the profit? In other
words, if the trader were going for a 20-pip move, should the stop be 60 pips? The idea
of a positive ratio of reward to risk is at the surface a good one. Having bigger winners
than losers is critical to profitability. But having an arbitrary ratio between a profit target
and a stop loss is just that—arbitrary. It does not reflect the reality of the dynamics of the
price movements and actual conditions facing the trader. It does not take into account
whether there have been increases in volatility in the range. Additionally, if a trader is
achieving a very good win-loss ratio, then it is possible to be profitable even if there are
more losers than winners.
Consider the situation where a trader has a ratio of 60 percent wins. If the trader had
a risk of 20 pips per trade and a profit of 20 pips per trade, the result would be (6 wins
× 20) – (4 losers × 20), or +40 pips. In contrast, a trader with a ratio of 40 percent wins
and an average profit of 40 pips with an average loss of 20 pips would result in a net of
(4 wins × 40) – (6 losers × 20), or the same 40 pips. In other words, the reward-to-risk
ratio depends on the performance results. A very good trader can, in fact, have a high
negative ratio and still be profitable.




By ABE COFNAS