Stop-Loss Exits: what is the best way to set it optimally

As long as the human factor is involved – nothing is one hundred percent perfect. Since this fact also applies to trading, plans have to be made for the inevitable. And the peaks and valleys of trading involve inevitable losses, as well as account drawdowns.

How well you manage your risk and the fact that not all trades will be winners will determine how you can withstand the valleys long enough to enjoy the peaks.

How well are you familiar with the Forex money management?

Casinos understand that not every hand of poker or blackjack will be a winner for the house. But, they have a winning edge over the public and over time they know they will win more than they lose. It is a game of probabilities, just as in trading.

Let’s dive into this topic deeper and check why Stop Loss is an integral element of any Forex money management system.

Superior Trader’s Mindset

You may be asking yourself, “Isn’t this obvious?” That may be true, but depending on your personal experience level, people have a different understanding of this concept.

The masters will have a deeper familiarity with loss and losing trades. They know their average dollar win to average dollar loss statistics and their ratio of wins to losses. They possess what is known as “The Trader’s Mindset” and superior trading psychology and confidence.

But, even the experienced trader may on occasion forget that “not every trade will be a winner”, especially after a string of the profitable trades, falling prey to the perception of being invincible and becoming vulnerable to emotional trading.

We are all human, so no matter how expert we become, and no matter how fantastic our profits are, we need to remember the root of all trading evil— is the evil of forgetting to fully acknowledge and accept the risk of potential loss in every trade.

Why you don’t want to have a winning streak right from the start if you are new to trading

It may take some time for the beginner to fully recognize that they won’t be right 100 percent of the time. The worst thing that can happen to novice entering the markets is to have a winning streak right from the beginning. Then they really start believing all the late night infomercials advertising how to get rich quick.

As a novice, they may have miscalculated their stops or have used no stops at all. They may have taken on far too much risk for their account size. The winners will, essentially, reward them for bad behavior and offer the false sense of security that they know what they are doing.

Everybody has seen the disclaimers that say “past results do not a guarantee the future performance.” That means if the one has a few big winners, there is no “guarantee” that winners will continue.

You must never let your guard down because the market is a living, breathing creature with ups and downs. So a word of caution to the beginners: keep your eye on your money management.

A few notes for the perfectionists

If we agree that there will be times that you are wrong, how will the perfectionists be able to live with that?

Pilots, among few others, are well known for having little tolerance for imperfection. It is interesting because pilots are the first to understand all the notion of paper trading (similar to flight simulator), strict adherence to the trading rules (similar to using the preflight checklist), and having iron discipline.

The only thing they have difficulty with is stop-outs. When you’re 30,000 miles in the air, there is no room for being wrong (or stop-outs), because if you are wrong it means crashing and burning. So when they get stopped out, they need to rewire their thinking. A stop-out is just a small flight-plan correction—it should not be viewed as crashing and burning.

The perfectionists need to remember that stop-outs are a part of trading, and being wrong is normal, if you correct the course in a timely manner. At the end of the trading day it is the big picture that matters.

How then can we maintain profitability?

If we are never going to achieve the absolute perfection in our trades, then the answer to “How can we maintain profitability?” is the age-old concept of “cut your losses short and let your wins ride.”

That will require discipline and adherence to some guidelines:

1. Find a trading approach that is compatible with your comfort zone.
2. Paper trade it to determine your win ratio and payoff ratio. These numbers will be needed to design your money management approach.
3. Always use a market dynamics based stop-loss exit to cut losses short.
4. Consistently adhere to your stop-loss rules.
5. Determine proper trade size for your current account and limit your risk per trade.
6. Maintain records to be able to monitor your profit/loss performance on a daily basis, so you can know immediately if the system is failing due to a change in market conditions or other factors.
7. Go back to the drawing board to find the cause if your system is failing.

Why do you need to have a stop?

This assumes that you already have an approach that tells you when to enter a trade. After knowing where to enter, the first question is, do you know where to get out—before you open the position?

The second question – is this exit based on market dynamics? Are you accounting for market conditions that indicate you how much “breathing” room your trade needs so that you don’t get repeatedly stopped out?

Stop-loss exits are necessary conditions leading to profitability. You also need to determine how stop-loss exits need to be selected to avoid excessive stop-outs. The more trades you place, the higher your costs of doing business will be due to the commission fees. You can grow your profits by increasing the win ratio, thereby reducing your commission expense.

Sensible money management is intimately linked to the trading approach you use. By choosing your system carefully, and identifying high-probability stop-loss exits based on current market dynamics, you will decrease your number of stop-outs.

Try It Yourself

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This way you can spend as much time as you need to sharpen your money management skills and grow your confidence as a professional trader.