A Beginner’s Guide to Adding a Stop Loss to Your Trade

6 min read
Nenad Kerkez

Nenad Kerkez

Head of Trading

Have you ever struggled with placing a stop loss? Have a you ever wondered why you needed one in the first pace? Or perhaps you see your stop loss get hit on a regularly basis? 

This article is here to help explain why a stop loss is an absolute must when trading (unless you have tons of experience). And we will show you where you can find the best places for adding such a stop loss, or SL.

Key Characteristics Of Stop Loss

The most important aspect when protecting your trading capital is adding a stop loss on each trade. Why?

Entering a trade setup without a SL means that traders are risking all of their trading capital and more. Yes, it is that dangerous. Especially if higher leverage is used.

The SL provides an exit point which in turn allows traders to measure and limit their risk. Both points are important.

First, it also provides traders with a method how to measure their risk per trade, which in turn limits the of any trading account. Traders can measure the risk by taking into account the entry, the SL, and then the lot size.

  • For instance, a 0.1 lot size with a 50 pip stop loss means a risk of about $50 (1 micro lot with 50 pip SL = 5$).
  • Then you can calculate what that amount is worth in relationship to your account: $50 with a $5000 capital is equal to 1% risk.

Second, limiting the risk is a critical point for any risk management plan. If a trader loses for instance 20% of their account on each trade, then the trading capital will probably disappear very soon. However, if a trader limit the risk to 1% per trade, any one loss will not to any serious damage to the trading capital.

Where Should You Place the SL?

The stop loss (SL) should be placed at a logical level in the market. With logic we mean market structure and not a fixed number of pips. Let us explain.

A fixed number of pips does not take advantage of key levels in the market. However, traders who use support and resistance (S&R) levels do benefit from an extra ‘wall’ of protection.

This is because historical buyers and sellers have already placed their imprint. Price tends to repeat itself and hence it often respects confirmed S&R levels.

When trading Forex, CFD or any online trading business, technical analysis (TA) offers the best method to find traders to understand future movements and the path of price action.

Therefore, the most ‘logical’ levels to add a stop loss are always based on TA and placed beyond S&R and invalidation levels.

Here we will explain why the stop loss is a strong tool for the traders: to expect the reversal in the market trends.

  • The SLs and TPs are very meaningful decision points when trading FOREX.
  • The location of SL should be such that if it gets touched or executed then traders should be expecting reversals, depending on the time frame. This is shown in figure .
  • Every trade does has its own dimensions that let us choose the amount of pips for the SL and TP.
  • The entry level is also critical because it impacts the risk to reward ratio.

One of the main reason why traders lose money is simply because they place the stop loss in the wrong location.

     Fig1: GBP/JPY Bearish Trade Setup

Example Of Trade Setups:

Let us take a look at the GBP/JPY bearish and GBP/USD bullish trade setups as shown below in figure 1 and 2. In this example, the entry point is around the 50 to 55% fib level.

Keep in mind that wave 4 may not retrace beyond the wave 1 and the 61.8% Fib level, which is the invalidation level. The Stop Loss will therefore be placed at the 61.8%. Now there are two scenarios:

  • If SL does not gets hit or executed, profits for the target will be on cards in the bearish move (as shown in figure 1).
  • If SL gets hit or executed, trader should cancel out expectation for further bullish move (as shown in figure 2) and could reanalyse the charts whether bearish setups are available.

Conclusion:

All in all, Stop Loss levels are a must for all traders. Here are some closing thoughts:

  • Always prepare the trade plan.
  • Stop loss should be at invalidation level.
  • Consider stop loss to be a key point for direction/trend.
  • If SL gets hit then trader could expect a reversal.
  • Elliott Wave labeling helps with accuracy.

    Fig2: GBPUSD Bullish Trade Setup

 

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