Forex Stop Losses: Big V';s Small

By: Mark Rayner
In the world of Forex, good advice is usually delivered out of context. One of the worse cases is: "Your stop level must always be one half of your trade size". But what does this Really Mean? While this sounds like great advice, the realities of trading are very different.

For example, if you are targeting 40 pips, your stop should be no more than 20 pips. On the surface it seems like a logical idea, but when you dig deeper, you'll discover the idea is fatally flawed. The main problem is that all currencies fluctuate within the bigger trend. Take a look at the following example. Using the logic above, we take 10 trades on the GBP/USD. Targeting 40 pips, our stop should be placed 20 pips away from entry. It is now assumed that we are risking 50%. On our sample of 10 trades, we were stopped out 7 times and we won 3.

The reason for these poor results is the GBP/USD fluctuates constantly. Even if the pair is not trending it will rise and fall 40 pips or more. let's do the math: 7 Losers: 7 x 20 = 140 pips of losses
3 Winners: 3 x 40 = 120 pips of Wins
Total = -20 pip loss. A better option. If we increased our stop level to 40, and target 40, that would be considered wrong. We are risking 40 to try to gain 40. However... When we test the 40 pip stop on the same 10 trades, we are only stopped out 4 times. Because the trades were given more room to fluctuate, the stop was not hit so many times. Let's do the math: 4 Losers: 4 x 40 = 160 pips of losses
6 Winners: 6 x 40 = 240 pips of Wins
Total = +80 pip Gain. When deciding our stop levels, we cannot ignore the market and how it moves.

So is this advice wrong? If it is taken out of context, yes.

To use this advice correctly, you need to work forwards not backwards. If you decide that 40 pips is a safe stop level, for the pair you are trading. Try to take trades that target 2 times that level. If you do not think the market has 80 pips of movement, you may decide to pass on that trade. I personally still take trades that target the same level as the stop. This is because I have faith in my trading system, and know that even in an extremely bad month, I’ll win 6 out of 10 trades. I would still be profitable.

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