The importance of a well placed stop loss
I checked on the progress of a GBPUSD trade last night and discovered that I had been “stopped out”. It was just before bedtime so I did what a lot of traders do when they discover a losing trade. I cursed under my breath, decided to look at it closely in the morning and went to bed. Now I’m assuming that when trading, you all use a stop loss. If so hooorah and good for you! If not then all I can say is
“Hmmmm, you might want to rethink that one”
Stop losses are a vital part of risk management and I’ll discuss managing risk another time, today I’d like to talk about where best to place your stop loss. The golden rule of placing a stop is that there must be a technical reason to place your stop where you have. By technical reason, I mean your stop should either be at a previous level of support and resistance , or at a psychological number or below a pivot point for instance. You then need to calculate how much of your trading capital you are risking based on the number of pips between your entry and your stop. Then multiply that by the volume you are trading. Now as you can see from the diagram below I placed my stop at the 1.64000 level.
This was in accordance with my trading strategy which stipulates that when entering a trade, my stop should be placed at the red line which is in fact the 55 exponential moving average. So far so good, however my mentor always said that “you should also always place your stop a few pips below the nearest level of support and resistance”. In this case, I should have placed my stop a few pips below the 1.64000 level. 1.64040 would have been a better place. This trade was very frustrating as those few pips cost me what would have otherwise been a great 2:1 winning trade. Still, that’s just the way it goes in trading sometimes. As traders all we can do is learn from our mistakes and strive to be better one trade at a time.
Do you know when to use the right kind of strategy?
A few months back, I was playing a video game with friends called ‘Buzz’. It’s a music themed quiz game where you had to choose how many points you would win or lose depending on whether you got a question right or wrong. The points spread was 500, 400, 300, 200 and 100. My friend Big ‘G’, always went for the maximum points every time. He’s just that type of guy. Needless to say his experience of the game was one heck of a rollercoaster ride and he eventually finished last. I based my points on how confident I felt about the theme before the question was readout and I eventually finished 2nd out of 5 players.
photo credit: Helga Weber
You see, there are thousands of strategies out there, some good, some bad. That said, the most important thing about using a trading strategy in my opinion is selecting the correct strategy for the right market conditions. Many traders miss this thought process and go straight to the ‘how can I get this strategy to work for me’ phase, i.e their minds are focussed on ‘how can I make as many points as possible in the shortest amount of time’. Three things are essentially wrong with this:
- They may not have properly assessed and deduced what the current dominant market psychology is, e.g. fear, greed, confusion etc.
- They may then have selected the wrong type of strategy to use e.g, using a trend following strategy during a ‘ranging’ market cycle.
- They may not have chosen the right amount to trade based on how confident they were at trading that particular setup.
As traders, every now and then we come into possession of a new strategy. Usually someone, somewhere swears by its usefulness and we are often too eager to get it working for us. The new strategy may well be the answer to all our prayers, however, if we use the strategy during the wrong market conditions to which it was designed, we are doomed to achieving poor results. The knock-on effect of this is that after a string of losses, the temptation is to begin searching for yet another strategy to try. It is important to have a number of different strategies for different market conditions but as previously mentioned, the most important thing is to identify is the dominant market psychology first, then go to your toolbox of strategies and select the most appropriate one.
It’s okay not to trade
For many of us, It is all too easy to “over” trade. By this I mean, “forcing the issue”, or feeling that because we have sat at our computers with our trading platform and charts loaded, the session must end with us placing a trade. After all, we should have something to show for the last hours screen time right? Wrong! This mindset will result in only one outcome, overtrading. 80% of my trading time is spent reviewing fundamentals and analysing price action and only 20% is actually spent trading.
photo credit: matuko amini
In my experience, it is better to be patient and gain a greater understanding of past price action as well as key support and resistance levels. By knowing these key levels in advance, you are much better placed to tackle the markets and you will ensure that you have a much higher rate of success with your trades.
In the heat of the moment, when presented with a potentially good trading setup, it’s all too easy to get a rush of blood to the head and enter the trade. At these moments, many of us fall into the age-old trap of convincing ourselves to enter the trade. It is very important to also think of reasons why we should not enter the trade. For instance, If the trading setup is at a key level of support and resistance or approaching a major psychological number (numbers that end in 00), this one very good reason not to enter the trade! Plus, if you have already done your homework, and plotted out all the key levels of support and resistance on your daily charts, all you need to do is glance at this before you enter the trade to make sure there is nothing in the way between your entry and your first target. It is even better, to set your charts up so that when you plotlines of support and resistance on your daily chart, these lines are automatically redrawn on copies of your smaller time frame charts. This is the setup I use and it has proved very useful indeed.
Why so much emphasis on the daily chart you might ask? It is my opinion, that the daily chart is the most psychologically relevant timeframe of them all. For longer term traders, this is the time frame most used for entries and for intraday traders, this is also the timeframe most used but to confirm whether or not they are trading with the overall trend of that currency pair or going against the grain. One of the first things I do once I begin my trading session, is to view the daily chart of all of my currency pairs. This is definitely my starting point. Apart from drawing in key levels of support and resistance, it is from this timeframe that I form my opinion as to whether the market is in an uptrend, downtrend or ranging cycle. I also find it very useful to do my daily timeframe analysis within a one year ‘look back’, this way I am always consistently looking at the same amount of data on the daily timeframe.
The power of keeping good records
I have been told by many successful traders that “keeping good records”, is one of the vital keys to becoming a great trader. The positive outcomes of keeping the records are:
• Following your trading strategy rules
• Analysis of past trade performance
• Consistency
Often when we spot a potential trade set up, the tendency for us can be to “speed up”, so as not to “miss” the trading opportunity. This is a mistake, you see when we humans get excited (which often happens when trading), some psychological and physiological changes occur. Our heart rate quickens, giving us a sense of anxiety and there is a reduction in the oxygen supply to the parts of the brain that deal with logic. This explains why so many traders have had that experience of spotting a good trading set up, immediately launching themselves into entering the trade, only to realise after they’ve pulled the trigger that either the setup wasn’t that great to begin with, or that the setup was sound but because of their haste and anxiety, they made mistakes and poorly executed their entry. Following your trading strategy rules By having a trading strategy properly documented and to hand, you will greatly minimise the amount of times that you enter the wrong trades. It is often better to create an additional summarised trading strategy checklist that can be easily and quickly followed in the heat of the moment. Analysis of past trade performance The truth is we often have the greatest learning experiences when we make mistakes. The problem with not keeping good records of your trades is that you will not have documented evidence of what mistakes you have made or are still making! Consistency By following your trading strategy rules and by keeping good records of all your trades, you will be able to achieve another vital key to becoming a great trader, consistency. It is only by being consistent with our trading, that we are able to look back with a different perspective and easily analyse, learn and improve. If you do things consistently, patterns in your behaviour become very easy to spot. Why is this important? By spotting your good behavioural patterns, you will be able to reinforce what you are doing right and by spotting your bad behavioural patterns, you’ll be able to correct them and improve your trading performance.
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