What is a stop loss and why we need one?

Stop Loss is an automatic order that closes our trade once price reaches a specified level. Usually when opening an order we have a choice of entering our stop loss level.

There are 2 types, if we place a sell order then we need to place a stop loss at a certain distance above our entry price. If we place a buy order we need to place a stop loss at a certain distance below our entry price. For Example lets say on EURUSD the price is at 1.22432 and we want to sell so, if we want a 20 pip stop loss. We place it at 1.22632.

Using a stop loss in this way is a method of only risking a small amount of typically between 1% – 5% of our total trading capital per trade. And hence also limiting the losses on our account which puts our minds at rest when trading. The most important part of trading is psychology or put another way its about how you react to that price when it triggers your signal. Or put another way it will affect how you perform as a trader.

When I trade I usually risk about 20 pips per trade. This means if I’m trading at £1 per pip then my risk is £20 and means I would need a total bank of £400 if I was to feel comfortable taking that trade. I wouldn’t feel comfortable if I was risking any more than that and if I don’t feel comfortable then it will affect my trading actions. For example I might hesitate and get in late, or if I see profit but I’m scared I might take profit but this might suffocate a really good trade. So, as we realise getting a stop loss at a level were comfortable with is very important for your psychology which overall will affect your trading decisions which will affect your performance. Just like any sport to that matter.

I’ve often heard it being said that “a true professional trader doesn’t care if he wins or losses”. Well this is true because he knows his method of trading will very probably bring in profit over the long term. What is important is how many trades we win compared to how many we lose and were only going to know this over time. So this is why whether you win or loss if you are a true professional it simply doesn’t matter on one particular day. Its when were losing over many months that tells us we aren’t doing well and need to re evaluate things.

BUT don’t rely on stop loss techniques alone to make your system profitable!

Its a subject of much debate I’m sure on exactly how you use a stop and I’m sure there is more books and websites out there giving much scope on this topic but as far as I see a true long term profitable trading system although I would say needs a stop loss and is very important. It shouldn’t rely on a stop loss technique to be profitable as I’m sure it won’t work long term as usually these types of system end up wiping out your entire capital when things go wrong.

A good trading system must get the direction right the majority of the time otherwise its relying on the stop method which in my view is not the path to long term profitable trading. Lets take Roulette as an example. Now, I’m a fan of online roulette but I can tell you from experience there is no system that can beat roulette no matter what you do. There are I’ve heard over 7000 roulette systems out there. Of them there will be variations of those that rely on a betting method called Martingale. Let me briefly explain:

Martingale basically aims to recoup a loss by doubling the next bet. The allure is strong and quite rightly as so it appears you can’t lose but oh yes you can. You see eventually a long losing streak will wipe out the risk capital of the player. If you look at the roulette player from short term then it will appear they are doing well but if you look at their playing over many months they are very likely to have lost their entire risk capital at some point.

Example:

Balance £100

Bet £1 on Red it Loses Balance = £99

Bet £2 on Red it Wins Balance = £101

Bet £1 on Red it Wins Balance = £102

Bet £1 on Red it Loses Balance = £101

Bet £2 on Red it Loses Balance = £99

Bet £4 on Red it Loses Balance = £95

Bet £8 on Red it Loses Balance = £87

Bet £16 on Red it Loses Balance = £71

Bet £32 on Red it Loses Balance = £39

Bet £64 on Red it Loses Balance = £39

Can’t place any more bets and there’s no way you can get back up to £103 so you have lost

This is an example of relying on a flawed money management strategy to win and not relying on a solid system. Because quite simply you can’t get information or anything to give you an edge on a number. If we do flat betting on Roulette then the casino edge will slowly diminish our balance also. Quite simply can only rely on luck to make profit here.

If we take the stock market though it has elements of predictability, it isn’t fixed odds betting, the chances of price moving in or out of your favour changes all the time. Yes it can be hard but a good system can get it right otherwise there would be no long term profitable traders which I can assure you there are.

Some of the most well known stop loss methods I know of:

Trailing stop

This is where the stop level moves along with the price at a predefined level as set by the trader. For example lets say the price is 1.22432 and we want to sell so we place our stop at 1.22632. Now if price moves lower to 1.22332 then our stop will also trail behind and move to 1.22532 without any input from the trader. Now if the price moves against us the stop will remain at 1.22532 which in effect will protect us from a bigger loss if we left it at 1.22632.

Although this method does have its pro’s and con’s.

Pro’s = It minimizes losses

Con’s = It doesn’t allow your trade to breathe and therefore diminishes some possible good moves.

But it all depends on the type of system you use. I think its not bad for if your system predicts breakouts.

Break Even

When price moves in profit by a certain amount as set by the trader the stop loss is moved from the stop loss level to the entry price there bye protecting the trader from any losses.

For example lets say the price is 1.22432 and we want to sell so we place our stop at 1.22632. If we think we should move stop to break even when we are in profit by 20 pips. When price reaches 1.22232 then the stop is moved from 1.22632 to 1.22432 our entry level.

I find this type of stop loss method good for swing trading or when your system plans on holding the trade over a day for a good trend.

Although this method does have its pro’s and con’s.

Pro’s = It allows you to hold onto your trade for as long as you think price will move in your favour.

Con’s = As markets do fluctuate it sometimes can stop you out and so miss out on any profits.

It all depends on how the market behaves and it think this method relies on further judgement of the markets behaviour.

50% Lock In

This method involves firstly allowing the trade to breathe and so is suited to holding the trade over a day or 2 and locking in half of what’s there. Its good because it allows our trade to breathe and is in line with the golden rule of holding on to winners.

I would normally trade this as so:

I would enter a buy order at 8am say the EURUSD at 1.22432 with a 20 pip stop loss at 1.22232. I come back at 12pm to see price is now at 1.23032 which means im in profit by 60 pips. So I would move my stop to a 50% level at 1.22732, so now I know ive profited no matter what but still have a possibility of making more profit if price was to move higher.

Stop Reversal

This is when we place an opposite order on a stop loss level. This is an effective method for counteracting when you get the trade wrong. It works thus, you would enter a buy order on the EURUSD at 1.22432 with a 20 pip stop loss at 1.22232 but you would also place an opposite version of that sell order at this stop loss level of 1.22232.

My personal favourite is holding over days while stopping the major peaks

With my system you might only be risking 20 pips but every 3-4 trades place will see profits of over 100 pips because using my favourite is the 50% lock in with a slight difference. Instead of locking in the 50% level I instead look at the previous major price peaks and place my stop at these levels. Price peaks give a better idea of true market direction so what better way to hold onto that direction than using price peaks, as although price fluctuates, if its for example shorting then price shouldn’t rise above the previous peaks until there is a major direction change.

What is profit factor ratio and your ideal risk to reward ratio?

Ive seen many many trading systems and they all look great on paper but there is one thing they never show and its down to you to find your self. Its the Profit Factor Ratio or PFR. This is where you find the ratio of you profits to your losses. If over many many trades its still above 1 then your system is profitable. This one major point is what all trading systems don’t actually show you, but is what you need to be a true

profitable trader.

There was 1 system I remember in particular which I guess stuck with me and is what led me to the goal of holding a trade over a few days for maximum profits while risking only a small amount. Obviously I can’t give names here but the main promise was most trades make 100+ pips profit by lunchtime. Now like all systems you read about they always show you the good while glossing over the bad. What they don’t show you is the reality of how that system performs. You can only see the reality after you have bought the system and experienced trading it yourself.

So we must backtest and find the systems true PFR.

From experience my trades usually end up with a risk reward of 1 to 4 meaning for every £1 invested I expect a £4 return for if that trade wins. This statement is irrelevant what really matters is the profit factor ratio. Or simply your profits / losses. If its above 1 then your in profit. It depends on how high above 1 as to how fast we can profit and how much we profit can make. So when trading I always inspect my system is working and making sure the PFR is > 1.

For example lets say I placed 1000 trades with a strike rate of 1 in 4, and each winning trade to make £20 while a losing trade makes £5. We can expect 250 winners and 750 losers. Sounds bad at first, 750 losers Oh No! but watch:

250 winners at £20 a win = £5000

750 losers at £5 a loss = £3750

So,

Profit / Loss = PFR

5000 / 3750 = 1.33

Our PFR is 1.33 that is I would say a realistic PFR. Trading at £1 a pip means we will profit £1250 over 1000 trades placed. £1250 profit from a £100 investment is serious money making potential. Of course this is a conservative PFR there are many systems out there with higher PFR. I’ve read that most systems realistically reach just under 2.0. Mine is 1.33 I can live with that.