Zen And The Art of determining a Stop - Loss Price
Brief:
A "Stop-loss" is used to prevent a greater loss then a trader needs to assume on any given trade. The Stop-loss is a feature that enables you to limit the amount you are willing to risk in each trade depending on your trading strategy (each trader should have one). The Stop-loss is price determined, meaning you need to decide at what market price do you want the trade to automatically be closed at. When setting the Stop-loss price, you should consider the following parameters: What is the current market dynamic? How much money are you willing to risk? What is your estimated trade duration (minutes? hours?).
Don't take the Stop-loss decision lightly!
What are your options?
1. Before you open the trade, you should already decide how much money you are willing to lose if the market goes against you.Best practices of money management suggest risking no more than a certain % of your total account balance in a single trade. 4 % is considered a reasonable loss per trade.
2. Learn current and historical market volatility level (view the Market tab in the Guardian Angel for updated analysis).
3. Try to estimate the duration of your trade (minutes, hours, days) – the longer the trade, the more you will be able to capture large market moves although a larger stop-loss may be required.
4. Mind the risk level (leverage) - some trade sizes you choose to open can be large as compared to your current equity and thus can limit your stop loss range. Meaning, because you are assuming such a large amount of risk, the stop-loss may be too tight and result in forced trade termination. In other words, the leverage may not fit the necessary stop loss range that is required by market's volatility
Overview:
Stop-loss is a great tool but people tend to underestimate it – they just think "let's risk $50" and open a trade. However, if you want to trade like a professional, perhaps you should go deeper. Stop-losses can be tricky, but if you learn to master its secrets it will serve you well.
What's the big deal?
Let's say a trader has a good idea of where the market is going – up or down. But it could be that the market goes in the expected direction but with a lot of price fluctuation (volatile market behavior) or with little price changes (calm market behavior). The more volatile the market is – the higher the chances are that a trade will be forced terminated prematurely, like when a stop-loss catches (even if the trader had predicted the market's direction well!).
Take a look at the two examples below:
1. In this example you can see an up- trending market with low volatility.
2. In the example below, you can see an up-trending market with high volatility. The trader may predict the market direction well (point 1 – open a Long positions), but if he sets a stop-loss without considering the volatility (point 2), the trade may result in an unnecessary loss.
Remember that at any given time one market can be volatile where another can be very calm!
Now, what does the trade's duration have to do with market volatility? Volatility is measured as the size of changes in market prices over a specific time period. Therefore the shorter the trade's duration – the smaller the range the market could take.
The Guardian Angel can show you a reasonable stop loss range for different market volatility levels, based on the ATR method: the stop loss level is determined by a distance factor in pips, multiplying the current ATR measuring. The Guardian Angel offers a factor of market move during one hour to produce a stop loss range. This is only one of many strategies to determine stop-loss. If the trader has made a different analysis of his stop-loss policy, he may change the factor to a different desired level inside the Guardian Angel to show this.
When trades are taking longer, you may require a different factor with different calculations.
To summarize: when you open a trade, consider the amount of money you are willing to risk, market volatility level, and expected trade duration. Only then carefully set the stop loss price that would fit your trading plan.