Setting Stop Levels When Trading – How, Why & Where

Setting stop levels is an often overlooked aspect of trading, and yet stops are absolutely crucial to trading success.  Many traders spend hours, days and years searching for the ideal entry criteria, when they could simply adjust how they are setting stop levels to become more successful.

Too often traders place stops at arbitrary levels which means they get stopped out before a real move happens.  Magnifying the problem, traders often begin to narrow stops even more in order to reduce losses and in turn end up trading low quality signals more frequently.  Often problems can be related back to position sizing.  A trader should only risk a certain amount of money on a trade, this means the stop levels and position size need to be carefully planned.  Determining proper position size is crucial in trading as position sizes can make or break a trader. Once the stop level is determined then appropriate position size needs to be taken so that no more than 1% of capital is risked on any single trade.

In forex trading stops and position sizing are very easily managed by most any forex broker, as order (entries, stop levels, trailing stops) are very customizable.  Same with any market (but the example below is a forex example) so there is no reason for this to be a problem.

If you can only risk $100 on a trade (this means you have about $10,000 in capital in your account as $100 represents 1% of that amount), don’t take 5 mini lots if the proper stop level is 50 pips away (this is a risk of about $250). Many traders take 5 mini lots anyway, and just make their stop 20 pips ($100 risk, but stop is not at proper level).   This is a sure way to get stopped out more often than not.  Instead, reduce the size of your position and keep the appropriate stop level.  In this case, take 2 mini lots with a 50 pip stop.

Remember that stop levels, in dollar terms will be a little different each time.  Don’t use one stop level all the time, use your charts and volatility measure to determine what the appropriate stop level is…then determine your position size accordingly.

Stops should be placed at levels which indicate that the original trade idea was wrong. Chart patterns allow us to do this in a methodical way.

Setting Stop Levels with Chart Patterns

We have a clear set up, which provides profit targets upon a breakout, but the pattern also provides a stop level in that if a breakout occurs in one direction, the opposite side of the formation offers us our stop level.

If a break downward occurs from a triangle chart formation, a break above the top of the formation shows that the downward break was false therefore our stop level should is placed just outside the pattern on the opposite side of the breakout.  This stop level can also be a stop and reverse.  A stop and reverse (in this case) means we go from being short the pair, to long, with our original short position be stopped out and a new long position being taken.  Whether a stop is used, or a stop and reverse method, is up to individual trader.

In another example, a head and shoulders pattern, once completed, can have a stop placed above the right shoulder.  If rates move back above this shoulder we no longer have a classic pattern.  We may still be able to trade the pattern but we want to stop our position out to see what develops.

Basically a stop level gives us an idea of our risk.  Being aware of the risk is a very important aspect trading, and the risk should always be considered before making a trade.  If the potential risk is equal to or more than what we can reasonably expect to make on a profitable trade then the trade should be avoided. Ideally the profit potential should outweigh the downside by a factor of two or more.

Remember, false breakouts are just as tradable as real breakouts. By setting stop levels are reasonable price levels we control our risk and can adapt to the market more readily as we will not be clinging to positions which which are not serving us.

For additional information on trading please see the Trading Tutorials page.

Cory Mitchell, CMT

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By Cory Mitchell, CMT