Many traders think that the secret to successful trading lies purely in finding a way of knowing when a market is going to behave in a certain way. While this is of course essential, what so many participants never realise is the equal importance of limiting your potential losses through using a stop loss.
Why should you use a stop loss? Well, take driving – how many times a week/day/month do you crash? I would hope relatively few times. But how often do you wear a seatbelt? Every day, right? That’s because if you did crash the result would be quite likely be fatal. Exactly the same can be said of trading – if the markets go against you and you have no stop loss (the trading equivalent of a seatbelt), it can quite likely be fatal.
The importance of using a stop loss has been reiterated by many experienced market participants, including the veteran fund manager Larry Hite in his wise observation that “If you do not manage the risk, eventually they will carry you out.” His point being that no matter how much money you make trading, if you expose yourself to unnecessary risk, you will fail at some point. This was spectacularly shown to be the case with our recent financial crisis for example there was little to no respect for risk.
You may think a stop loss limits you in terms of unnecessarily being stopped out and missing out on potential gains. While this may happen at times, you need to look at the bigger picture and think of your long term financial goals. In fact, far from being a hindrance, a stop loss can be an integral part of creating a successful trading strategy. For example, if you form a strategy on the basis of risking one dollar and aiming to make four dollars profit, you only need to be right one time out of four in order to break even, and if you’re only right half the time (the same probability of flipping a coin), you will make a profit in the long run.
So, how do you find the right stop loss level? Test, test and test some more. Look at the time frame you use, can you see a level at which the price has bounced off? If so, you could make this the stop loss because it has formed a barrier which the security has proven to be supported by. You w?uld then need to work out how much you can potentially make from the trade by looking back at historical examples of how much a similar trade made in the past, or by usng tools such as Bollinger Bands to work out the potential volatility. You can then work out hew much you are going to risk by dividing the potential ratio you want to profit by.
Whatever system you choose to trade by, make sure at the root of it is a sensible stop-loss strategy. This may be the more boring side of the global forex markets, but it will ensure you have enough money to still be able to trade if you happen to be wrong.