There are a number of ways to choose where to place your trading stop, and these will vary depending on your trading strategy, especially when considering your risk limit and profit target. However, most stops fall into the categories of technical stops, equity stops and volatility stops.
A good rule of thumb is that if you enter a trade for a technical reason, you should exit that trade for a technical reason.
So if opened a trade when an asset price bounced off a support (or resistance) level, your profit target would be when the asset approaches the resistance (or support level). This also means you can use the original support (or resistance) level as your stop. Similarly, if you are trading a breakout, once the asset price passes the support or resistance level, that level will become your new stop.
Another example would be if you bought a stock or went long on a forex pair because a short-term moving average crossed above a long-term moving average – if the short-term moving average falls back below the long-term average, this could be your signal to exit. As far as a stop loss is concerned, you could make the longer-term average your stop loss, adjusting it as the average moves with the stock or currency price.
An equity stop is essentially placing a stop loss at the maximum amount of equity you are willing to lose on a trade.
A common recommendation is to risk no more than 2% of your equity per trade. So, if you had $10,000 in your account, you could risk $200 per trade. If you were trading one standard forex contract, the stop would be about 20 pips from your entry price (though this amount can vary depending on the currency pair you are trading – a one pip movement, or movement of 0.0001 – is worth 10 units of the second-named currency. So, in the EUR/USD pair, 20 pips is 200 US dollars. However, if the second-named currency was the EUR, GBP, CHF, AUD or SGD, 20 pips would range from 200 British pounds to 200 Singapore dollars, which are worth very different amounts when converted into a common currency. This is why it’s essential to convert your potential losses into your currency, to ensure that the amount you are risking is actually 2% of your capital).
The market you trade can impact the method you use to place your stop. Some stocks are not frequently traded, and can, consequently, either make very small, steady movements, or be subject to gapping. By contrast, the most commonly traded forex pairs can be very volatile and, in a 24-hour market, can move considerably when you are not at your computer.
To account for volatility when placing your stop, it is a good idea to factor in the average true range (ATR) of the asset concerned. The true range is the largest of:
- The most recent period’s high minus the most recent period’s low
- The most recent period’s high minus the previous close
- The most recent period’s low minus the previous close
The ATR is simply the average of the true range over a number of periods. By placing a stop at a percentage of the ATR, you account for the fact that some assets are more volatile than others. For example, the ATR of the EUR/USD at the time of writing is 170 pips, while the ATR of the AUD/NZD is 85 pips. This means that a stop of 20 pips will be triggered much more easily in the EUR/USD than in the AUD/NZD, potentially stopping you out before the currency trends in your favour. Typically, assets with higher ATRs require wider stops, while those with lower ATRs require tighter stops. Determining the percentage of the ATR to use will depend on the length of your trades – if you are a day trader, it is likely to be very small, perhaps only 10% of the ATR. However, if you are keeping positions open for a number of days or weeks, it is a good idea to gauge the average size of intra-day price swings, which could result in you placing your stop at 100% of the ATR.
Your trading style, including the length of your trades, the volatility of your chosen market, the technical tools you use to enter a trade and your risk tolerance, will determine the method of stop placement that will work best for you. This article was written by Jacqueline Pretty – IG Markets – CFD Trading. No representation or warranty is given as to the accuracy or completeness of the above information, consequently any person acting on it does so entirely at his or her own risk. IG Markets accepts no responsibility for any use that may be made of these comments and for any consequences that result.