Setting the best stop always has been and always will be the bane of traders.
We have all experienced the anger and crazy-making that goes along with setting a stop far from the current price only to be stopped out by ONE pip and then having the price quickly completely reverse and go on to reach our original target. Is there anything more frustrating???
I think any discussion of this topic will be great for EA programmers as well as manual traders. Someone programming an EA has back testing to quickly tell them which stop to use, but I still think there may be some useful ideas here.
Obviously scalpers, day traders, and swing traders all have different stops, but the concepts are universal. All styles of traders are welcome to participate, but please remember the multi-approach audience. Please add your thoughts.
HOW TO SET STOPS
1. ATR. Whatever time frame you use, consider the ATR. Place your stop just beyond the ATR. ATR-Stops is a great indicator worth playing with. (attached) Notice below that I have a sandwich between the 1 and the 5 min stops. I would be using the stop on the 5 min chart for sure, but I might decide to go ahead and close out the position since I am getting consolidation on the 1 min chart.
2. Daily ATR. If you only swing-trade, then consider the daily ATR. Place your stop just beyond the daily ATR. LFL-ATR is a great indicator that I use in my trading. (attached). I love this indicator because it shows me the 80% ATR line as well. This can help me know when to start taking profits if I am in a trade. But sometimes the value area of the market is fundamentally shifting. And if you were wrong, you want to GET OUT. But where? Just above the red line is a perfect place for swing traders.
3. Money Risk stop loss. If you risk 5% per trade, then your maximum stop loss is set for you by your position size so that the total risked is 5%. If you cut your position size in half, then you can have a double-sized stop and maintain the same risk. But the most fun of all is when you see the effects of cutting the stop in half and doubling the position size to maintain the 5%. Now you see why some traders successfully load up with many full lots. They are really not risking very much when they use small stops. But this leads us to the very important #4 . . .
4. "Expectancy formula" and Fixed pip stop. If you simply choose a fixed pip stop loss make sure you have some statistical basis for it. Here is a great discussion on TraderMike.net: Trading 101:Expectancy. Here is the beginning of the article:
"Expectancy along with position sizing are probably the two most
important factors in trading/investing success. Sadly most people have
never even heard of the concept. Out of the 30 or so trading books I’ve
read only a few even touch on any aspect of money management. Only one
of those handful of books discussed expectancy. In simple terms,
expectancy is the average amount you can expect to win (or lose) per
dollar at risk. Here’s the formula for expectancy: "
Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)
Here is one of my own expectancy tables based on a series of 10-pip winners with stops set at 50, 40, 30, 15, and 7 pips. (This is based on some of MY past trading and is only meant as an example of how to set up a table.) Going through this exercise has been a great help for me to see why despite the many great winners I have had, using an inappropriately large stop is just dumb.
5. Eliminate the skewed outliers. Observing a skewed set of negative excursions, WD Gann taught a statistical method for setting stops. He said to examine all your trades from a sample of at least 30 trades and determine the "adverse excursion" of each trade. Where is the 80% threshold? That is your stop. The last 20% are all dangerous trades. For me, this is historically at about 24 pips. So I should set my stop at 25 pips based on his method. Those that are beyond the 25 pips are usually hugely bad trades anyway, so just get rid of them! I love this method and it helped me identify the 30 pip stop that I usually use when providing a signal (adding 5 pips from slippage and to make it easy to calculate!)
6. Recent Swing High or Low. ZigZag is a great indicator to watch, but hard to trade with because it lags. Nevertheless, it is a great instructor. Using support and resistance in my trading is foundational. Once the stops outside the recent range are hit, then prices often keep going that direction. Out of all the options I am presenting, this one is the one that rings truest to me, but it requires constant adjustments. This is not a fixed 30 or 20 pip stop, but must be determined immediately after each trade.
7. Get out "Immediately". In all my 7 years of trading, no idea has been more powerful than this one shared by The Phantom of the Pits. When a trade goes against you, GET OUT IMMEDIATELY. Yes, your winning % will drop significantly, and you will have many break-even trades, but the risk/reward ratio goes way up. The best futures traders use this method. Rarely is it taught. It is counter intuitive and stressful. But long term it makes the most sense.
There you have it! My best 7 ideas on how to set stops. Please add your own ideas to this all-important topic.
Great question. The % risk is a function of (position size * stop loss)/account balance. So as long as you lower one when you increase the other, you can adjusting either the position size or the stop to maintain the risk. For example, I often trade with JPY based pairs and USD based pairs. Well, it just so happens that in this very volatile "BOJ-Gone Crazy" environment, the JPY pairs (i.e. EUR/JPY) have significantly more volatility than the USD pairs (EUR/USD). What can I do? What do I do? I simply cut my position size in half and double my stop--and my risk (as a % of my account) has not changed.
As far as the order goes (stop vs size), you obviously have read a lot more than me, and perhaps setting the stop first is ideal. But I actually do figure it out using the expectancy table shown above BEFORE I start trading with the position and max stop size that I use.
Great question. The % risk is a function of (position size * stop loss)/account balance. So as long as you lower one when you increase the other, you can adjusting either the position size or the stop to maintain the risk. For example, I often trade with JPY based pairs and USD based pairs. Well, it just so happens that in this very volatile "BOJ-Gone Crazy" environment, the JPY pairs (i.e. EUR/JPY) have significantly more volatility than the USD pairs (EUR/USD). What can I do? What do I do? I simply cut my position size in half and double my stop and my risk (as a % of my account) has not changed.
As far as the order goes (stop vs size), you obviously have read a lot more than me, and perhaps that is ideal. But I actually do figure it out using the expectancy table shown above BEFORE I start trading with the position and max stop size that I use.
Well, you caught me. ATR was actually the first stop-determination method that I listed because I DO think that it is one of the best.
However, I have found that when I trade manually (which is all the time), I am super lazy! It is way easier for me to just to hit "modify trade" in MT4 after I make an entry, and then set a number for the stop and take profit and hit the button. And those SL and TP numbers then stay there for the next trade. I take from 5 to 20 trades a day and calculating each SL and TP level is highly taxing. Simplicity is a main factor for me and my tiny brain.
Now, if I started to use #6 (recent swing high or swing low) then I would definitely have to calculate it. And it would probably be very close to the results of the ATR stop that I listed above.
There are many ways to "skin this cat" and the important thing is to actually THINK about what you are doing, WHY you are doing it, and then to DO IT. To this day, I still take some highly risky trades with huge (or no) stops in place. I often regret it. As good as I am at extracting pips from the market, I still get bit and it hurts. The only sane thing to do long term is to define your rules and method and then STICK TO THEM.
Thoughts on stops in general. I just saw the results of one trading competition and they bragged about how the top 10 winners all had 100% winning trades. How short sighted. They showed the profit, but didn't show the draw down it took to keep those 100% winners.
Nobody likes to lose! The emotion involved in a losing trade is extremely powerful. I understand completely why someone would rather move a stop than be stopped out, especially when they "know" the market it about to reverse BIG TIME.
But we all have to remember that any particular trade and even the whole market COULD just keep on going up forever! (Especially with the new US Fed Chair, Janet Yellin who appears to strongly favor QE and money printing.)
So on investing, swing trading, day trading, or even scalping is it not better to get out with "a small cut" (small loss) than to lose a finger, an arm, or even your whole life? OF COURSE IT IS.
So take your small stops and move on to the next trade. Set them and never move them wider. There will be other trades. There will be other days. You have to be in the game to play and win. We are here not be "right", but to make money.