I personally believe that having a great entry is best way to improve your trading results. Others argue that the exit is the only thing that really matters and a monkey could throw darts at a board to pick stocks, and with the right exit, that strategy could still be profitable.
That might be mathematically true. But I've found that most traders need to enter at a point where they can place a stop loss that makes sense and have a good shot at making a reasonable profit.
In reality, the are both important, but a good entry makes your job much easier.
But how do you know where to set your stop loss?
Is Your Stop Loss Too Tight? The Arguments for Both
On one hand, it's exciting to set a very tight stop and potentially get a 9R+ trade. After all, the smaller your risk, the higher your chances of having a payout that is multiple times what you have at stake. But that also means that you will probably get stopped out more often.
On the other hand, the idea of giving your trade room to breathe is enticing too. The markets ebb and flow like the ocean and sometimes there is a large ebb, before the next flow. However, if you give your trade too much room, your returns can suffer because your winners won't pay for your losers.
So which one is better?
The Right Way to Choose the Best Stop Loss For You
The bottom line is that your stop loss should be set at a level where your assumptions about the trade will be proven wrong.
Some traders will tell you that a tight stop loss of 8 to 12 pips is best. Others will tell you that a wide stop of 200 pips or more, is best. Many will tell you to use an indicator like the ATR.
Who should you believe?
Well, they are probably all right…in their own way. As long as they are actually trading what they teach, and not just talking out of their asses, then their method is the best for them.
However, therein lies the secret to your failure.
If their method does not match with your trading personality, then there's a very high probability that you will not be able to trade that method successfully.
It's like dating someone who snores like a horse…and you are a light sleeper.
Eventually something has to give, if you want to get a good night's sleep.
So just like dating is a way to try out a relationship before you make any long term commitments, testing a trading system is away to try out a system before you risk any real money.
Here's how to do it…
First, start with the system, as it is taught. It doesn't matter where you get the trading system from. The trading method might work as-is, without any tweaks.
To learn some trading systems go here.
Do a complete round of backtesting on the currency pair and timeframe of your choice. It's important to do a complete test so you get an idea of what you can expect. I recommend using Forex Tester, but there is other software out there.
Then change the stop loss and do a complete round of testing again.
Compare your results.
This will tell you which stop loss should work better.
But don't stop there. Test as many different stop loss levels as you need to.
Feel free to experiment at this point. It's only testing.
Once you have one that works in backtesting it's time to move to forward testing. This is the step before going live, so use a demo account or a very small real money account.
Forward testing will allow you to iron out any quirks that are going on between your backtesting and forward testing.
When you have something that works in both rounds of testing, then you are ready to go live.
Going through this process will help you understand the best place to put your stops.
How to Fix Artificially Tight Stops
Before I end this post, there is one more issue that I must address. Some traders purposely set very tight stops because the correct stop loss is “too far away” and they will lose too much money.
If this is you, then you are simply trading with the wrong broker.
Trading mini lots (1,000 units) with a $1,000 account is a recipe for disaster. No wonder you want to keep your stops uber tight.
However, trading that same account with nano lots will allow you to take the correct amount of risk, usually 1% or less. When you are able to take exactly the same amount of risk on each trade, you will make a lot more money.
I hope that this guide has helped you understand what it takes to figure out if your stops are too tight, or not. There's no fancy indicator or formula.
Many people will be too lazy to do the testing to figure this out.
But not you, right?!
If you follow this process, you will know once and for all, if your stops are too tight, or if they are just right.
Let me know how it went in the comments below…
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