Position Management – Stop Losses
One of the most important aspects of position management is knowing how to use your stop losses effectively and when to cut trades. There are several types of stop losses to be aware of, let’s look at a few of them now.
Technical versus the money point stop loss
The first one we will look at is the technical versus money point stop loss. Stops should never be set around arbitrary levels, but based around levels set on technicals and your loss limit. Lets look at the chart below to illustrate the difference.
The Resistance zone in the Aussie is set between 1.0280-1.0295. Lets assume we are looking to get short in this zone targeting 1.0281 to sell just prior to the last challenge of the resistance zone. Many traders new to FX will choose their stop loss based on their acceptable loss limit without giving regard to the obvious stop loss area, which in this example is above 1.0300. This practice is known as a money point stop loss. I have seen evened seasoned traders on trading floors make this basic mistake.
In the example below if we wish to risk a maximum USD 420 loss and assuming a cut on our technical based stop at 1.0302 (21pts) we can afford to sell AUD/USD 200,000 at 1.0281. Having done this we would have successfully been short for the subsequent move lower cutting the trade at 1.0225, yielding a profit of USD 1120 (assuming no roll). If however we had aggressively sold AUD/USD 700,000 at 1.0281, and used our maximum 420 USD loss limit placing our stop at our money point limit of 1.0287 would have seen us stopped at the top in the uptick to 1.02887 and missing the following down move.
Time Based Stop Loss
The time based stop loss recognises the multi-dimensional aspect of the time and reward versus risk with more time in the market exposing a trader to higher risk. A time based stop loss addresses this point with the trader cutting the trade after a certain period if the trade has failed to reach the take profit target zone. This is done because the premise in which the trade was initially based is likely to be no longer valid as the previous momentum that has been carrying the currency to the take profit zone during the recent range has dissipated exposing the trader to a counter move. The chart below illustrates this point where a long entry at .8154 is cut at .8186 after the trader reasons that having spent almost a week trading sideways that a move to the target sell zones is unlikely to occur before a downside move below the support based stop loss level.
Close to market stop losses
Typically employed by day traders and scalpers a ‘Close to market’ stop loss needs little explaining. It is where a trader places a stop loss close to the price action and is normally based around key levels or knowledge of a sizeable order in the market. Traders using these stops must have faith that their liquidity provider is showing correct market pricing and that their stop losses will not be executed ‘out of market’. Tight spreads play a vital role in making this type of trading successful.
Support and Resistance based stop losses
Support and Resistance stop losses are perhaps the most widely employed stop losses in the market; an understanding of how to use them is critical to your trading. Lets look at the chart below of the USD/JPY to help our understanding of how to deploy such stop losses in a dynamic moving market.
Two bullish hammer candlesticks and a minor downtrend line break are sufficient for us to initiate a long trade at 78.05. A run to 78.584 is followed by a ~ 50% retracement (of the 77.943-78.584 move) back to 78.272. A few hours later the USD/JPY successfully holds around this level again at 78.283 before breaking the old highs of 78.584, at this point we can move our stop loss up to around 78.27 to protect our profits using the support holds as evidence to back the move. With only 11/12 pips initially at risk on the trade moving our stop loss during the 78.584-78.272 down-move to the 78.25/30 area would have made little sense as we could quite easily have been flushed out of the trade.
It is only after evidence of support that we should move the stop. We repeat the process again later moving the stop loss after new higher support is found around 78.60 being careful not to expose our position until protection is evident from support levels.
Trend line Support and Resistance based stop losses
Trend-lines are a form of Support and Resistance lines only differing from those discussed above in that they are sloping rather and horizontal. Therefore we can apply the same rules of moving stop losses around support and resistance lines to trend lines also. Lets look at the chart below to see how this is done. The first two grey arrows show the first tradable touches into the uptrend support zone after the uptrend line was drawn after the prior low. Stops should be placed on these trades below the orange lower uptrend channel line. Further trades were presented towards the end of the uptrend this time trading from the short side off the upper trend channel. The inability of prices to reach the upper trend channel at the end of the move higher indicate a loss of momentum warning us of a change in trend which is later confirmed by the break of the lower up-trend channel line (see first long arrow).
From here the lower up-trend channel line acts as resistance against the subsequent up-move although the ~20 pip false break of the channel line does confuse. Adept traders should have been able to negotiate this false break however noting previous highs around 1.0845 (this high was exceeded by around only 10 pips on the false break). From here we see a downtrend ensue with three nice tradable moves (see first three arrows in the down channel). The transition from a down trending market to sideways trading market is again alluded to by an inability of prices to reach the lower downtrend channel near the end of the trend. During the three-week sideways phase we see the prior upper downtrend channel zone acting as support on three occasions.
The sudden change to a new sharp down trend is hard to detect, with the break of the 1.0225/30 April 11 support lows being the major flag. Breaks of the steep down-trend upper channel line in late May warn of a further impending trend change with the same line acting as support on the last major exhaustive down move before the Aussie moved higher for the remainder of the year.