Markets can move in three different ways:
When you expect a market to go up, you take a long position. A long position means that you buy the security and expect to sell it for a higher price if the market goes up. The difference between the two prices is your profit. For example:
This is the 1 minute chart for AUD/CAD. The price closed above the moving average (red line) which tells me there is a potential buy signal. Because this strategy is trading reversals, we expect the price to go up. We place a long position and a stop loss. A few minutes later:
This trade turned out to be a winner. How much money you make depends on your risk management. In this case I used a risk/reward ratio of 2.36:
I risk 1% to make 2.36%. Tradingview also show you the amount of pips. You can use the amount of pips in online position size calulators to determine your position size. In this case the stop loss is 4.7 pips from the entry price and the take profit is 11.1 pips from the entry price. Meaning I risk 4.7 pips to win 11.1 pips. Which equals a 1:2.36 risk reward ratio. How to find the correct position size goes beyond this article but if you want to know more you can read about managing risk in my ultimate day trading guide.
Knowing where to place your profit target takes practice and depends on the security you are trading.
When you expect a market to go down, you take a short position. When taking a short position you borrow the asset from your broker (or someone else) and sell it right away for the current market price. When the price of the asset moves down you can buy it back cheaper. Once you bought it at a lower price you can repay the broker the assets you borrowed and the difference is your profit. An example:
This is the same chart as above only now price moved down and closed below the moving average. This is my signal to get in a short position. In this case I lost the trade:
The sell signal was good but the price did not drop enough to make a profit and got stopped out eventually. Or my stop loss was too high. If you lower your stop loss your risk reward increases:
This would turn into a risk reward of 1:4 which is pretty high. In this case the profit target could be lowered and it would be in profit. But this is also a very tight stop loss. A tight stop loss means you don’t have much room to play with. If the price goes up just a few pips, your stop loss is hit.
Where to place a stop loss order:
“When do I think I’m certainly wrong about my predicted outcome”
Always place your stop loss on the spot where you think you are wrong. In the above short example, my prediction that the price will drop is wrong if the price moves above the moving average again. So that is where I set my stop loss. Your stop loss placement might be different.
You should never take short or long positions without a stop loss. This can be very dangerous because what will happen if you are wrong? Or if something happens that you did not expect? Using a stop loss is a fail-save to guard you from your analysis in the case you are wrong.
Keep in mind that although a stop loss acts as a fail-save, it’s never 100% safe. In markets with lower liquidity this can cause big troubles.
What is liquidity?
Reward: +10 XP 0 0 0
A stop loss is not actually an order that is placed in the orderbook. A stop loss is simply a trigger for your broker to put in a market sell order. But that does not mean the orderbook has enough liquidity to meet that request. If prices drop too fast you might sell your asset for much lower prices you have set in your stop loss. In that case, you have to pay the broker for all the losses you made. Even if that means you busted your account. Your account can have a negative balance.
The only 100% safe way to protect your stop loss is by using a secured stop loss. This way you are 100% sure that you will sell your position for the exact amount you set in your stop loss. Problem is, secured stop losses cost you a premium. Which means you have to increase your profit target to make the same rewards vs an unsecured stop loss. The premium price is just too high to always use secured stop losses. The best way to avoid this problem is to trade high liquidity markets (like forex).
Another way to protect your account against a negative balance is negative account balance protection. Many brokers offer this protection but also many do not. Make a decision if you want to take this risk.
Maybe you heard or read about stop loss hunting. Stop loss hunting is very common. It means that other people or institutions are hunting stop losses. They want to trigger your stop loss and take your money. This is also called fake breakouts. Fake breakouts happen when the price is seemingly going in a certain direction. People think prices will go up and place their orders. But just a few moments later the price is not going up but plummeting fast. Many stop losses get hit and take people out of the market.
Putting your stop losses at obvious price points is bad practice. Most traders use the same charts and indicators. Every more advanced trader knows about trading psychology, support and trend lines. Beginners tend to put stop losses at obvious places and get stopped. Even though their initial thought was correct about where the price might go.
All of the above is just a simple overview. There is a lot more to it than just placing stop entry, exit point and stop losses. If you want to know more about risk management and stop losses you should read my ultimate day trading guide.
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