Beginners avoid placing a stop-loss order because of the difficulty in striking a balance between two conflicting criteria – avoiding unnecessary triggers and preventing wider losses. If the stop-loss price is too close then there will be frequent losses with exits from even good entries. On the other hand, a stop-loss order far away from the entry point will result in rare but wider losses. The ideal stop-loss order should be the one, which would not cause a premature exit because of spikes but provides an early exit in case of a trend reversal.
I would suggest using the following tested methods to avoid premature stop-loss triggers:
Guest post by Andriy Moraru of Earn Forex
1. Percentage stop
This is the most basic approach to the placement of stop-loss orders and is very popular among new traders. The stop-loss price is determined based on the maximum percentage risk a trader is willing to take on the account size. This way, a stop-loss is placed at the longest distance possible given the percentage risk and the trade size. For example, if the percentage risk is 2% and the account size is $10,000 then a trader closes the position upon reaching a loss of $200; with one mini-lot of EUR/USD it means a stop-loss distance of 200 pips, which is about four times the average daily range for this currency pair. As a result, the possibility of premature stop-loss execution is almost entirely eliminated. Of course, this method is not recommended except for some very special cases when normal technical or fundamental analysis stop-loss placement cannot be applied.
2. Bollinger Band stop
The strategy is based on the volatility of a given asset. It is a well known fact that volatility reflects the probable price movement of a security in a given period of time. Thus, by keeping the stop-loss order in accordance to the volatility of a security, premature exits can be prevented.
To achieve the objective, a Bollinger Band indicator is used to visually measure the volatility. The stop-loss order is then placed above (short position) or below (long position) the Bollinger band. Such a process prevents premature exit from the trade.
3. Trend line stop
The process involves identifying the major support/resistance for a security’s price. Once a long position is taken based on a tested trading system, the stop-loss order is placed below the major support. Similarly, for a short position, a stop-loss order is placed few notches above the major resistance. The strategy is based on the assumption that if price closes above resistance or below a support then the forecast is no longer valid. It is important to have some buffer between the actual stop-loss level and the support/resistance level.
4. Moving average method
To begin with, a higher period moving average (50 or 100-period) is included in the price chart. Now, the stop-loss order is placed above the moving average for a short position and vice-versa. Care should be taken to place the stop-loss order little away from the moving average. The strategy ensures that a trade is taken away only when there is a firm trend reversal. Although it is a popular method, it has its weakness – shorter period MAs are often violated by the price action while the longer period MAs result in too stop-loss distance that is sometimes too big.
5. ATR (Average True Range) method
This is another volatility-based strategy, which professionals often apply. The value of ATR indicates the average price movement (volatility) of a security over a given period of time. For example, in the case of a currency pair, if the ATR value equals 100 on a daily chart for a standard ATR input parameter of 14, then it implies that the currency pair has moved 100 pips per day on an average for the past 14 days. Thus, a stop-loss price in this method is determined using a certain percentage of the average true range value over a given period. Considering the same example above, if a trader uses ATR-based stop of 100 pips or more, then the stop-loss order will be triggered only if the volatility increases above the normal range. Thus, the chance of a premature trigger is lessened.
6. Parabolic SAR stop
It is also one of the easiest methods to avoid a premature exit from a trade. To implement the strategy, a parabolic SAR indicator is attached to the price chart. The indicator is displayed as a series of small dots above or below the price bar to indicate the prevailing trend. An uptrend is indicated by the formation of SAR below the price while a downtrend is suggested by the formation of SAR above the price. At the beginning of a new trend, the price starts diverging from the parabolic SAR. As momentum begins to slow, the indicator (dots on price chart) closes down (converges) the gap to finally touch the price bar. The parabolic SAR then begins to form on the other side of the price indicating an impending reversal. If a long position is taken then a stop-loss is placed few notches below the parabolic SAR level. Similarly, a stop-loss order is placed few notches above the parabolic SAR level after taking a short position. The process ensures that fake trend reversals do not create a premature exit. However, it should be remembered that parabolic SAR stop will not work successfully in a range bound market.
7. High/Low stop
The strategy involves placing a stop-loss order below the recent high or low. For example, if a trader uses a 1hr chart to enter a long trade then the stop-loss order is placed below the lowest price registered in the past one hour. Likewise, a trader using an H1 chart to enter a short trade should place a stop-loss order above the highest traded price in the past one hour. Thus, only a fresh movement against the prevailing trend can remove the stop thereby eliminating the possibility of a premature exit from a trade. This method is best suited for scalping trading strategies.
8. Fibonacci stops
The Fibonacci levels are undeniably a major concept in the mind of traders when deciding the market turn around points. The 61.8% Fibo level is a widely followed retracement level since it enables a trader to assess whether an asset is currently bullish or bearish. Under this strategy, a stop-loss order is placed few notches above the 61.8% level in the case of a short position. In the case of a long position, the stop-loss order is placed few notches below the 61.8% level. The process has the potential to avoid the premature exit from a trade. Only when there is a firm reversal, the stop-loss order will be hit.
9. Standard deviation based stops
This is another volatility-based method to calculate the stop-loss price level. The standard deviation values reflect the probable range of price surges of a security for a given period of time. By placing the stop-loss order at accurate number of standard deviations away from the average price of a security, a trader can make it highly improbable for the stop-loss to be triggered by random spikes. Unfortunately, this method assumes normal distribution of price changes, which is rarely a case in Forex trading.
10. Elliott wave based stops
The Elliott wave stop levels are determined by the three basic tenets of wave principle:
- Wave two can never retrace more than 100% of wave one: Based on this rule, once a long position is taken, a stop-loss order can be placed few notches below the origin of wave 1.
- Wave four may never end in the price territory of wave one: This rule assists in placing protective stops in anticipation of capturing the final (fifth) impulse wave move to new highs.
- Wave three may never be the shortest impulse wave among waves one, three and five: Using this rule, a stop-loss order can be placed for a short position. The stop-loss price should be at least few ticks above the price level where wave five becomes longer than wave three.
11. Pin bar stop
A pin bar can be identified visually. It would be a long bar protruding amidst other candles. The open and close of a pin bar will lie within the high and low of the previous candle. A trader can place a stop-loss order above the pin bar, after initiating a short position. The stop-loss would be taken out only if there is no trend reversal. Similarly, a stop-loss order for a long position can be placed below the pin the bar. The strategy can eliminate a lot of premature exits from trades.
12. Pivot based stop
The pivot based stop-loss strategy is quite common among traders. As per this strategy, a stop-loss order is placed a little above the pivot price after entering a short position. Similarly, a stop-loss order is placed a little below the pivot price after entering a long position. The pivot price point serves as a visual indicator of trend change. Thus, it can be a highly a reliable tool for placing perfect stop-loss orders. The problem is in determining a proper method for calculating pivot point location – there many ways to calculate a pivot point and they often provide contradicting results.
The strategies discussed above have withstood the test of time. However, it should be remembered that the best strategy for a particular scenario can be chosen only through experience. You can learn more about various trading strategies that involve their own stop-loss placement techniques on our website: http://www.earnforex.com/forex-strategy/Get the 5 most predictable currency pairs