Getting stopped out is a normal part of trading. You win some, you lose some. But could your stop loss placement be better? This post will teach you how to make a data-driven decision on the best place to put your stop losses.
The ideal place to set your stop losses is determined by these 2 factors:
- The stop loss should be at a level that proves that the entry idea was totally wrong
- The stop loss should have an acceptable historical win rate (relative to your overall trading strategy)
Now let's get into more detail on how this works in real-world trading…
Step 1: Create a Written Trading Plan
If you don't have a written trading plan, then it's absolutely necessary that you create one before you move on.
Download the free Trading Plan Worksheet PDF from this blog post.
In order for you to optimize your stop loss placement, you first need to have a consistent method of setting your stops.
Once you have concrete rules on where to place your stop loss, you can track the performance and see if there are ways to improve it.
Step 2: Backtest Your Trading Plan
Backtesting allows you get data on your stop loss plan, based on historical data. If you have never done backtesting, Forex is a great market to do it in because the software and data are relatively inexpensive and easy to use.
You can backtest with any of the Forex software programs out there:
- MetaTrader
- TradingView
- Forex Tester
To get started, read this guide on backtesting.
Review the results to see what works best. Remember to test on the timeframes and currency pairs that you will actually be trading.
Step 3: Adjust and Retest Your Trading Plan
If your backtesting wasn't profitable, it's time to experiment with your trading plan.
Even if your backtest went well, also consider testing other ideas.
Don't be afraid to get really creative.
Sometimes the weirdest ideas end up being the most profitable!
Once you have a strategy that tests well, it's time to move on to step 4.
Step 4: Track Your Results
Now it's time to track your results in Beta Testing. Trade your strategy in a demo account and track the results.
You can use a trading journal like RazorJournal, Evernote or a simple Excel spreadsheet.
Backtesting does have limitations, so this is where you can flush out the bugs in your trading strategy.
If your Beta Testing doesn't match your backtesting, then review your journal and adjust accordingly.
Common Stop Loss Placement Mistakes
Setting a Greedy Stop Loss
Many beginning traders like to set really tight stop losses, then dream about the Ferrari that they will buy with the 20X profit on their trades.
Then they get stopped out repeatedly…and quit.
Don't be greedy.
Setting really tight stops can work for some day traders, like this trader.
But in most cases, setting a wider stop loss usually leads to higher profits, especially if you are a swing trader. This is because you give the trade room to work itself out.
Otherwise, you are at the mercy of normal market volatility.
Trading Incorrect Lot Sizes
If you have a very small account (under $10,000), then you should consider trading nano lots. This will allow you to set the ideal stop loss level on every trade.
Many traders get stopped out because they use lot sizes that are too big for their account size. So they set a tighter stop loss because they simply cannot afford to take a 200 pip loss, even with micro lots.
Using nano lots will give your trades the room they need to breathe, while still taking a reasonable amount of risk.
Not Having a Tested Stop Loss Plan
I mentioned this before, but it's worth mentioning again. You need to have a black and white trading plan on how you will set your stop losses.
If you place your stop losses on “gut feel,” you have no way of figuring out how to improve your results because there's no consistency in your method.
But simply having a plan is not enough.
Your trading plan should be tested thoroughly to find out if it really works.
5 Ideas for Stop Loss Placement
If you want some new ideas on where to place your stop loss, here are five ideas that you can experiment with. Results will vary by trading strategy, but these are great starting points.
1. Beyond the Current Swing Low/High
The last price swing can be a good place to set your stop loss. It's usually a pretty obvious level.
If you are setting your stop loss on the other side of a candle, and you are getting stopped out often, then consider using a swing point instead.
Here's an example short trade. If you went short at the arrow, you could place your stop above the current swing high.
A big benefit of setting your stop loss beyond the last swing is that you can usually get in with a fairly small stop loss.
Of course, the downside is that you can get stopped out fairly easily because it's close to price action.
2. Beyond the Previous Swing High/Low
If the last swing point is too close for you, then consider using the previous swing level. Some traders may not like this idea because the stop loss can be considerably further away.
But if you do some testing, you might find that a bigger stop loss can actually lead to a higher winning percentage.
Don't take my word for it, test it for yourself.
This tip may not apply to your strategy. However, if you are setting your stop losses way too tight, this one simple tweak can greatly improve the profitability of your trading strategy.
Here's an example of the previous swing high on the short trade shown in the previous example.
3. Beyond a Moving Average
Setting your stop loss beyond a moving average can be a good strategy for trend following trading strategies. It provides a dynamic level of support or resistance that moves with the market.
You will probably have to test several different lookback periods to see what works best for you.
The best way to get started is to test some of the common settings out there.
For example, the 20, 50, 100 and 200 moving averages are popular, so start there. You don't have to test every single setting. It's all about what works pretty well, most of the time.
Some countertrend strategies can also use moving average stop losses, but this type of stop loss strategy is usually better for trending strategies.
However, you never know. Give it a test and see if it works for you.
4. Support and Resistance
Another great place to set your stop losses is beyond a key support or resistance level. Remember that these aren't precise lines…they are more like support and resistance zones.
So be sure to give price a little room to move and don't think that price will stop on a dime, just because you drew a line on your chart.
If you aren't sure on the best place to draw support and resistance levels, then read this post.
As a rule of thumb, the best places to draw your levels are places where price reacted strongly, from both the bottom and top. If price violates one of these levels, it's usually a good signal that your initial analysis of the chart was wrong.
Also remember to check for 50s and round numbers because they are often support or resistance levels.
5. Parabolic SAR (PSAR)
Finally, PSAR can be another great way to set your stop loss. The goal of this indicator is to show you when momentum has shifted.
Like any other indicator, it's not perfect. But it does a good job of following trends and creating more space when price is moving quickly.
It can be used for both trending and countertrend strategies.
Test it out and see how it works for you.
Here's what it looks like on a chart:
Conclusion
A final word of caution on stop loss placement…
It can be easy to get into over-optimize your stop loss placement.
That never works.
There is no perfect stop loss placement, trading is all about playing the percentages. But once you have data on what happens when you use a certain stop loss placement strategy, the best place to set your stop losses usually becomes obvious.
If you still don't know where to start, trade one position, then set a 1R profit target…and go from there.
Keep it simple.
Get started with testing some ideas right now.
If you have any questions on about this post, feel free to leave your comments below…
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