There are many recurring themes, that pop up in discussions on trading forums from time to time, and trading without a stop loss is one of the most prevalent. There appears to be two distinct reasons for many traders not to use stop losses; one is born out of ignorance, the other is a form of paranoid belief that brokers “hunt stop losses”. The belief is that brokers “know where your stop loss is positioned” and will cause spikes on the security on their platforms in order to take out positions where the majority of orders are clustered.
The first reason is simple to deal with; as traders mature and become accustomed to the market and the tools they have to trade in it, they’ll eventually defer to using a stop loss, or stop losses. At the very least they’ll use disaster stops, but they’ll also quickly realise that in order to adopt strict money management rules, on every trade they place into the market, they’ll have to define an exact percentage of risk on each and every trade, and this can only be done by using stops.
The second most prominent belief, that brokers hunt stop losses, is a bit trickier to deal with given this paranoid affliction generally affects the more experienced trader; generally the trader who, a few years into their new venture, blames a proportion of his or her losses to market manipulation. They therefore decide to trade without a stop on every trade, due to the mistaken belief that if the broker can’t see your stop then they can’t spike the security up or down to take out your stop.
It’s difficult to pinpoint exactly when this trading myth of stop hunting was fashioned into folklore, and why it’s remained so persistent over the years. It could relate to the need for many traders to find an excuse for their losses;
[quote]It can’t possibly be our individual failings, or the simple fact that none of us can predict the market, there must surely be another reason over and above human failure for our losses?[/quote]
If traders genuinely suspect that they’ve experienced a spike that has taken out their stop, then a simple comparison of another broker’s platform, or different charting package, in order to see if what the trader believes to be rogue market behaviour is apparent on another broker’s platform or price feed can allay any doubts. A call or email to the broker could then initiate a refund.
There is one element of truth in the stop loss argument, but traders have it the wrong way around; the market hunts stop losses not brokers. If traders put their stops close to looming round numbers, for example, 100.00 for WTI oil, when the market is close to $101 per barrel of oil, then the chances are that a massive amount of orders are placed at this level; buy, sell and stop loss orders. Therefore should the market gravitate towards this level (due to market sentiment falling) the likelihood of the 100.00 level being executed, and taking stops out with it, are very high. Similarly with the DJIA close to the 15,000 level it’s safe to assume that a massive amount of orders will be clustered at this level.
It cannot be emphasized enough just how imperative it is that traders trade with stop losses, but where to place them also confuses many traders as identifying the point at which your trade has finally become invalidated can prove difficult for many traders, particularly those who day trade. Moreover, how to calculate the risk and position size per trade can prove tricky for many new traders.
Calculating your position size
FXCC have a neat tool in our toolbox in order to help traders adjust their position size for each and every trade. It’s a simple calculator that computes the base currency risk for every trade. As an example it computes in the following manner;
You name the currency, the account size, the risk you’ll take per trade, the stop loss and the currency pair. You then receive a calculation for the currency amount, the units and (if trading FX) the lots.
Typically if your base currency is dollars and you have a $10,000 account and want to risk only 0.5% of your account size per trade, 20 pips on FX, then you’ll be risking $50 dollars and your lot size will be 0.250 lots with units at 25000.
Where to place stops
In the example we’ve provided it would typically be described as a fire and forget strategy; traders would be risking 20 pips, possibly a lot less as an average if measured over a set amount of trades, particularly if using a dynamic trailing stop. Traders might be looking for price to reach a certain level before ‘pulling the trigger’, or for their market order to be activated.
However, if using a swing trading strategy the calculation on where to place the stops can be more difficult and requires skill, judgement and experience or the effective use of certain indicators. Certain indicators, such as the PSAR, (the parabolic stop and reverse), will not only give traders an excellent method to enter the market, but moreover a perfect illustration of when the trade should be closed. If traders have entered when several indication conditions are met, including the PSAR, they could then exit, either at profit of by way of a stop, once the PSAR reverses. This is just one of many ways traders can effectively use indicators to close out profitable trades, or to end a losing trade, many traders preferring to use the oversold and overbought indications of the RSI, or the stochastic lines.
Whatever method traders choose to close a trade, deciding on a stop loss and then using a position size calculation/calculator, is absolutely imperative. There are no leading indicators, the closest is arguably price action by way of patterns developed using candles or Heikin Ashi bars. However, price action can be as notoriously unreliable to use as a swing trading strategy as many other key indicators, what’s more it relies on trader discretion for the opening and closing positions, which can hinder the exact placement of stops and the use of position size.
