Using Stop Loss Orders to Determine When to Enter a Trade

Many people enter into trades with little more than a desire for profit. In Forex we normally use between 50 – 400 to 1 leverage. Because of the large amount of leverage we are able to use, simply hoping for a profit is not enough. Traders need a solid plan before the pull they trigger. When planning any battle, successful generals begin at the retreat and work their way backwards. Traders should do the same. The first and most important decision is when to admit defeat and retreat. Survival to fight another day is more important that going down with the ship. This article proposes that traders take a different approach to figuring out when and where to place their next trade. The approach is simple. Just like the generals, start by figuring out when to get out. This may sound strange, but if you apply this idea to whatever other methods you are using to determine your entry signals, your bottom line should improve. The overall idea is simple, rather than first looking for a good entry point, look for a point where you would want to be stopped out. At this point you are probably saying “who ever wants to get stopped out?”

The answer is, not the majority. But let’s look at several statistics for a moment to get some perspective. Depending on who you believe, anywhere between 75-95% of all retail Forex traders blow out their account within one year. So it seems that the 5-25% of traders who are winning are doing something different then the majority who are losing. One of those main differences is not being bothered by getting stopped out. Many new traders complain that they hate trading with stops because they have been stopped out of a trade that almost immediately turned around and would have been a huge winner had they not run the stop. They take that to mean that they should not trade with stops. Trading without some kind of risk management is like playing Russian roulette by yourself, it may not be the next pull of the trigger that kills you, but pull it enough times and sooner or later it’s a sure thing. Trading without risk management is much the same. You may get away with it for a while, but the lesson you are learning will sooner or later prove deadly.

There are many forms of risk management, from the extremely complex, like cross hedging with options, to the very simple, such as using stops. The use of stop loss orders is one of the simplest and often most effective way to manage the risks of any given trade. The reason many traders have had a bad experience with using stops is not the fault of the stop itself, but rather the placement of the stop. Most traders get into a trade and then decide where to run a stop, if at all. They often have a fixed dollar amount that they are willing to risk per trade and they then place the stop loss order accordingly. All of this on the surface sounds like a good plan, but in practice it often leads to the scenario mentioned before, where the trade gets stopped out and then the market turns on a dime and goes the way the trader had originally anticipated, leaving them to mistakenly blame the stop. The individual points that led to the stop being placed are not bad in and of themselves, but put together this way, they often lead to the frustration mentioned above.

So let us look at these issues from another angle. Rather than getting into a trade and then deciding where to get out, let’s determine the exit point and let that dictate where we get in. To do this you will need a chart. Choose the chart’s time-frame based on how long you intend to hold the trade. If you only hold your trades for a few hours then a 15 or 60 minute chart should be fine. If you are more of a swing trader, then daily or even weekly charts would be best. Currencies tend to trend more than most other markets. However, they do not trend all the time. In fact the opposite is true. Most markets only trend about 30% of the time. The remaining 70% of the time they are trading within a range or chopping. Therefore, learning how to trade the chop is paramount if you want to be a trader for years to come. What follows is a simple yet effective way to trade the chop.

Trading the Chop

First, start by looking at long term support and resistance zones. Markets tend to have certain zones that they “bounce” off of time and time again before penetrating them. These zones are what you want to look for. Start with weekly or even monthly charts, no matter what time-frame you trade in. This will tell you in an instant whether the market is trending or choppy. Once you determine the underlying market condition, look for significant areas of support and resistance. Finally, move to a daily chart and then to a 60 minute chart. After going through these different time-frames you should be able to find a number of these zones. The best are those that coincide through all the time-frames. That will only happen if the market is at or near relative new highs or lows. When it does happen, though, it is time to sit up and pay attention. However, you do not need to wait for perfect conditions to use this method. You only need a support or resistance zone in whatever time-frame you are comfortable trading. Once you have identified these areas on a chart, you need to look closely and determine where that level would be broken and place your stops accordingly. A move through this level would signify that the market is breaking out from the previously established range. Once you find what the highest high is in the case of a resistance level, or lowest low in the case of a support level, you need to go a certain distance beyond that so you are not stopped out by a move of only one or two pips beyond these levels.

There are many ways to determine how much extra distance to give each market. One way that I have used is to simply look for the next closest Fibonacci number. This method is not scientific, but one that has served me well over the years. The Fibonacci sequence is one that was discovered by a mathematician all the way back in 13th century. The sequence is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144… For the purposes of using them for stops I normally only use 8, 13, 21, 34, 55, and 89. So if the last two digits of the highest high in a resistance zone had been 25, then you would use either 34 or 55 depending on which particular market it is in. The more volatile, or greater the average true range (ATR), the wider you should go.

Once you identify the zone you can then come up with your exact stop point.

Look at the daily chart of the USD/JPY and you can see that we have had significant resistance between roughly 121.50 and 122.25. Each time the market has reached this zone it has failed to follow through. There have been three attempts to break out from this zone, each one being lower than the last, forming a descending trend line. This is what you want to look for. Once you identify the zone you can then come up with your exact stop point. Simply find the recent highest high, in this case 121.66, and then find the next closest Fibonacci number (89) and you have your stop (121.89).

Determining your entry point

Now that you know where you are going to run your stop you can use that to determine your entry point. This is the point where you want determine how much actual money you are willing to risk on the trade. Most money managers will tell you to never invest more than 1% of your account on one trade. That rule really only works for traders using 50k or more. Most traders start with less and therefore are forced to break that rule. Starting with a $5,000 account and only risking 1% would mean that you can only risk $50 per trade, which in some cases is less than the bid/ask spread once you enter the trade, so it is obviously not realistic. But try to keep the amount you risk on any one trade as low as you can. Trading is a long-term endeavor. Do not fall into the trap of thinking that your next trade is “the big one” and you are sure it will work, and therefore put half or even all of your account into it. That is not money management, it is gambling. But let’s say you are comfortable risking $400 on a trade, or 40 pips on a 100k contract. Looking at a Daily chart of the USD/JPY, you can see that the most recent high was 121.66. Using the Fibonacci stop idea you would run your stop at 121.89 because 89 is the next closest Fibonacci number above 66. Now you have your stop well above a significant point of resistance. To calculate your entry point, simply subtract the 40 pips you are willing to risk from your stop point to arrive at 121.59 (121.89 – 40 = 121.59). The next day the market traded up to 121.63 so a limit order at 121.59 should have been filled. Once the order is filled, you can trail your stop with the market or move it to coincide with other support and resistance zones within the range. Your target would be somewhere near the bottom of the range. In this example your target would be a move to 119.50 or below.

So let’s review this method. First determine if the current market is trending or chopping. Then look to identify areas of support and or resistance. Next find the highest high in a recent resistance level or the lowest low in a support level. Determine the next closest Fibonacci number and you have your stop point. Then take the amount you are willing to risk per trade and either subtract it from your stop if it is a short trade or add it to your stop if it is a long trade. You now have both your stop and entry points, and you are only risking whatever amount you determined you were comfortable with. Your stop is placed at a level that signifies a change in the recent trend, and therefore is mush less random than most other stops. This method is not to be used exclusively, but it is one that can compliment whatever other indicators or patterns you are using to determine you next trade. This method should help you avoid getting stopped out at insignificant points that have you selling near highs and buying near lows within the established trading range.