Being a crucial weapon in the arsenal of risk management, “stop loss” allows traders to exit a losing trade at a pre-specified point before it becomes a devastating loss. With this integral trading tool, market participants can minimize potential losses by setting a limit on how much they are willing to lose on a trade.
In this article, we will discuss why using a stop loss is critical for long-term success as well as the top 5 mistakes you should absolutely avoid when using a stop loss.
Why use a stop loss?
When traversing the trading landscape, securing your financial capital should be a top priority. No matter how many pips you accumulate by winning trades, they are of no use if you eventually give them all back to the market due to poor risk management.
But it is a fact that in the challenging forex market, each and every trader falls prey to losing positions at some point. Because the market has its own trajectory, it can spontaneously change paths due to a variety of factors, such as traders’ sentiment, economic news, or other fundamental data.
While the losses can not be avoided entirely, they can be controlled using a stop loss. SL offers the traders a “safety net,” helping them to rein in the losses before they spiral out of control. In simple words, stop loss is an essential tool to prevent a small loss from turning into a large one, allowing you to survive and come back stronger for the next trade.
Here are the five mistakes you should avoid to take full advantage of stop-loss orders as an incorrect approach can end up costing you more than it benefits you.
1. Do not place the stop loss “too tight”
A common mistake most newbies make is placing the stop loss very close to the entry point in fear of losing too much. In such a case, the stop loss becomes counterintuitive as the price is not given enough room to breathe for heading in the speculated direction.
To understand better, suppose you buy EUR/USD at 1.08950 and place a tight SL at 1.08900. Now the price ultimately moves as per your prediction but only after plunging a few pips down. So, despite the price trending in your favor, a temporary dip causes you to miss out on potential gains as you get prematurely stopped out.
To avoid such situations, always take into account the volatility of the price and provide your positions enough room to move by not setting a stop loss too closely. Additionally, if you employ proper position sizing, you can kill two birds with one stone – placing a significantly spaced stop loss while also avoiding risking too much capital.
2. Avoid defining a “specific number of pips” for every stop-loss order
What most traders do wrong is specifying a “certain” number of pips as their stop loss target for EVERY trade.
Know that setting a stop loss based on arbitrary measurements like the number of pips or dollar amount instead of relying on technical analysis is a recipe for disaster. The market does not dance according to your calculated position size, rather, YOU have to adjust your strategy according to its ever-changing rhythm.
Typically, the proper approach is to determine the position of your stop loss through technical analysis, similar to how you select your entry point. Once you have done that, you can ascertain an appropriate position size accordingly.
3. Do not place the stop loss at “support or resistance” levels
While traders should consider the nearby support and resistance levels when placing a stop loss, setting it exactly on these zones is a bad idea. It is because the market often hits these key levels and it’s not uncommon for it to take a turn in the direction you predicted once it reaches them..
If you set your stop loss on top of a pivot level, it can lead to missed opportunities for profitable trades and result in unnecessary losses. Whereas by positioning your stop loss beyond a key support or resistance level, you can verify whether or not that level has been breached, thereby affirming the validity of your trade idea.
4. DO NOT widen your stop loss
It would not be wrong to say that the most common mistake made by traders is the widening of stop loss.
The whole idea of placing a stop loss is invalidated if you keep moving your stop loss in hopes of a market reversal! When the market reaches that point, where you have set the SL level, know that it’s game over for your trade. Don’t linger on the loss, instead embrace it as a valuable learning experience and swiftly move on to new trading opportunities.
Note that while widening your stop loss can save you from a loss many times, it can hit you very hard and wipe out all the benefits when things go south.
5. Never trade without a stop loss
Let us understand the disaster of not using a stop loss with a simple example.
Imagine two traders, Harry and Charlie, where Harry does not use a stop loss while trading, and Charlie consistently implements a stop loss of 2-3% of his account balance.
Harry keeps winning trades (without stop loss) as the market eventually reverses in his direction but Charlie suffers from SL hits almost 50% of the time. Now, suppose they both have positions on the opposite side during a day when the market behaves abnormally and moves in one direction, what do you think will happen to them?
Harry ends up blowing up his account with one trade! But Charlie remains in the game due to his planned and managed approach. While Harry had more winning trades due to the market reversing in his favor quite frequently, he had no protection against the sudden market shift.
And know that such bad days frequently come in the life of traders so keeping an unbridled strategy, without a stop loss, is a recipe for ruin.