September 07, 2017
By now, you already know what stop-loss orders are and why they are so important. You should never place a trade without a stop-loss, or you will blow your account sooner when the price goes against you. The forex market can sometimes be extremely volatile, especially during important news releases. Always place a stop-loss!
Now, let’s move on to cover the four main types of stop-losses. In general, you can place stop-loss orders based on four factors: percentage, price-action, volatility or time.
Stop-Loss Based on a Percentage of Your Account
This is the most basic type of stop-loss orders, which is based on a predetermined percentage of your account size. For example, if you decide to risk 2% of your account per trade, you would place a stop-loss which equals the 2% of your account size.
However, this is not a smart move. You should never place stops which are based only on the size of your account. Remember the previous chapter about how to determine your position size? Always place your stop according to the current market conditions, and then calculate the position size in order to risk a maximum of 2% of your account.
Stop-Loss Based on Support and Resistance Levels
A stop based on support and resistance levels is placed just below a support level, or above a resistance level. Support and resistance levels are price levels where the price has difficulties to break through, making these types of stops a much better decision than stop based on percentage of your account. Take a look at the following example. The EUR/GBP pair touched the red support line and sky-rocketed afterwards. A smart stop-loss would be the one marked below, just below the support line but with still enough room to account for a fake break of the support line.
Stop-Loss Based on Price Volatility
The next type of stop-loss orders are stops based on the average price volatility of a currency pair. This can be helpful as your stop can be triggered too early if you don’t take into account the average price volatility over a certain period of time. For example, the if the daily volatility of the GBP/JPY pair is 140 pips, you would be stopped out very soon if you take an intraday trade with a 15 pips stop-loss. There are a few methods to determine the volatility of a pair, such as using Bollinger Bands or the Average True Range indicator.
Bollinger Bands are a popular tool to measure price volatility. If you forgot, the bands widen when the price is volatile, and squeeze when the price is ranging. Based on this, you can simply put your stop-loss beyond the bands. The following chart shows how Bollinger Bands widen and squeeze depending on price volatility.
The Average True Range indicator measures the average volatility over a certain period of time. If you set the ATR to a setting of 10, the reading will show the average volatility in the last 10 periods. If you set it to 25 on a daily chart, it will show you the volatility over the last month. Placing a stop based on volatility becomes a lot easier with the help of Bollinger Bands and the ATR indicator.
Stop-Loss Based on Time
These stops, as the name suggests, are based on a predetermined period of time. You can decide to close your position when the NY-London session overlap is over, or by the end of the trading day. If you don’t want to hold your positions over the weekend, you can simply close them with the end of the trading day on Friday.