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Back to Basics, Part 2: The Definition of a Stop Loss by Sam Evans

 

This week I would like to revert back to the basics of successful trading once more and thought that there would be no better subject to cover than that of the Stop Loss. I have had the privilege of working with hundreds of new Forex students from around the world via both the Online Trading Academy classroom and Extended Learning Track (XLT) experience. Each and every one of these up and coming Forex traders has received the very same message from me and that is regarding the vital importance of using a stop loss. It sends a shiver down my spine when I meet a trader who does not use a stop order to protect their capital during a trade. Whenever I question their actions, the response is usually the same, much along the lines of, "If I use a stop, I could be taken out of a potential winning trade." I fully understand the psychology behind this way of thinking, as I once drifted along that line of mentality myself in the early days of my trading career; however, we should all recognize from the outset that the stop loss order is and will always be a trader's best friend. One day the market will just keep going against you and then what will you do? The stop loss prevents this from ever happening if used correctly.

Time and time again, I have stated that consistently profitable trading is not simply about winning frequently and making big bucks on each and every trade. Sure, if you do have a good run of winners this will undoubtedly help with the longevity of the account and serve to cover you in the event of a string of losses, but ultimately, the professional trader strives to be the very best risk manager he or she can be at all times. I have talked about the true math behind the market in previous articles and have shown you how any trader can still be highly profitable by having a greater number of overall losing trades than winning trades (see Perception vs Reality, Part 2: Consistent Wins or Consistent Profits). This unique dynamic of being able to maintain a low percentage hit rate while still making money is only possible by cutting losers off when they are small and allow the profits to run on those winners. The most effective way to achieve this outcome is by using a stop loss to get you out when you are wrong. This is a game of capital preservation, nothing more nothing less. Only a small percentage of the trading account should be risked on a trade; typically, between 1-2% on average. To ensure this worst-case scenario, we need to put in a physical Buy Stop order to protect money if a short position fails to work out, or place a Sell Stop order to cut off losing position if we were a buyer. By actually placing the order on the system (and not tinkering with it!), the trader has made a commitment to themselves to accept a small draw down if the trade is wrong and walk away. It is the most disciplined act we can carry out in our trading career, and a habit that will give us a real chance of success in the long run.

Yet, upon greater exploration of the stop loss order, we also discover that it holds further relevance in our trading methodology than we may have first thought...let me explain. My approach to the market and finding trades is a simple one. When trading Forex, I look objectively at a chart in an attempt to find only the lowest risk entries which provide that largest potential rewards. I have no problem getting it wrong a few times only to then find myself on the right side of the market the next day and letting the position run as far as possible. The only way I can stack the odds in my favor is by ensuring that I buy a pair as cheap as relatively possible or sell it when it is at an expensive price. I do this by scanning the charts for areas where there have been large imbalances between supply and demand in the past, and use these areas for my trades. As we all know, if supply exceeds demand, prices must fall; ergo if demand is greater than supply, then prices have to rise. Understanding this fact makes our job much easier as traders for it limits us to considering only the highest probability trades on offer. Take the chart below, for example:

 


Figure 1

 

From this 2-hour chart of the AUD/USD, we can see that prices were rallying up to an area which had previously experienced a large imbalance between the buyers and the sellers. The sellers ended up on the winning side, causing prices to fall strongly from this area of supply at around 0.9050. Having highlighted this area on my chart, I decided to place a set and forget OSO/OCO order to sell the AUD/USD short and place my stop loss order for protection of my account equity 10 pips above the pivot high of 0.9070. Later that day, I got triggered on the position and this was the result:

 


Figure 2

 

As we can see from the above chart, price did start to go in my direction before then rallying up to my stop loss price to take me out of the trade for a small loser. However, we can also see that prices did then tumble once again, breaking the 0.9000 area on the downside, which was in fact my first profit target for safety on the position. Little did I know things would turn out this way, but I had my plan in place and I followed it like always. Now you may think to yourself that I had a tough break on this trade, as prices did only rally 4 pips past my stop loss order before falling again, and maybe you would be right to think so. However, I have been doing this long enough now to understand and be comfortable with this outcome. This is something that sometimes just happens in the markets, but if you have a solid and disciplined trading plan to work from, you can learn to expect and deal with it when it happens. The very worst thing I could have done was to jump back into the trade after the stop out because as much as it would have worked this time, there are a huge number of other times when it would have not. You just have to remind yourself that it's the nature of the game and if you can't handle it, then don't get involved is what I say.

I do not regard this as a losing trade even though I lost money. I had a plan in place with an entry, targets and my stop loss for protection and I tell myself before I even place the order that whatever the outcome, the trade will be a success as it would have done one of the things I expected. I regard my stop loss as much more than just a tool to protect my capital. It is the most vital part of my order and I choose to define it as my protection against a Low Probability event. If I stack the odds in my favor then there are less chances of the stop being triggered, but this doesn't mean it still won't be hit from time to time...that's just the law of averages. Some you will win and some you will lose, but always stick to the plan and protect your account. The stop loss is both simple in nature and intrinsic in trade execution, thus providing us with our only true friend in the marketplace...keep yours close by.

Have a great week,

Sam Evans sevans@tradingacademy.com

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