This guide is all about how to set tight stop losses in forex. All of us have experienced the biggest agony of Forex trading: entering a trade and then seeing the market go flat. Or even worse: the market starts to actively move against our position (retrace).
The euphoria of having entered a trade then quickly vanishes as the stress starts to kick in. Second thoughts arise about everything: the trade idea, the entry, the setup, the correct interpretation of the market structure, etc. The emotions increase so strongly that they overwhelm the trader’s vision, and unfortunately the trading plan is thrown overboard. Why does this happen? What is going on, is there something wrong with the market? Those are questions Forex traders ask themselves.
This article will focus on the balance between entries and expected retracements. Adding tight stop losses can help mitigate risk and enhance your trading strategy. Here are a few recommended articles that can help familiarize yourself with this trading strategy:
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Setting Your Stop Loss - Jumping or Planning?
First of all, a distinction needs to be made between “jumping” in trades, also known as chasing the market and planning a trade deliberately. Unless a trade is executed within a second or two at maximum, every Forex trader will have to “live” through a period of retracement. The main difference between a trader who chases the trade setup and a trader who plans the trade deliberately is the conscious expectation of moves up and down. A trader who chases just takes a trade on the whim without planning.
This article is focusing on the deliberate Forex trader who has a plan. If you feel that your Forex trading is being negatively impacted by impulsive trading decisions and that you might be chasing the market, then please read this article on improving that.
How To Deal With Forex Market Retracements
Regardless of the fact why the market moves, all of us can observe the behavior which price exhibits: it moves in ups and downs, from level to level, from impulse to correction, from correction to impulse, in waves, in patterns, from Fib to Fib, bounces, breaks, pullbacks, continues etc. Everyone has their answer and vision. Everyone has their own tools and indicators.
The general conclusion is that: price is in a constant motion and is moving from one support and resistance to another. That concept is valid regardless of the trading approach (scalp, intra-day, intra-week, and intra-month/year) market environment (trend, reversals, and ranges) and entry methodology (confirmation, levels, and momentum breaks). What section of the market we trade, however, does depend on our chosen approach, desired market environment and entry methodology.
With that said, all traders will face the harsh reality of retracements during their trading. Every Forex trader trades a particular part of those natural ups and downs Price could threaten the stop loss; price could miss the take profit by a narrow margin and each chooses a particular combination of a stop loss level, an entry and a take profit. . Fact is that Forex traders must ignore certain smaller resistances in order for them to win a decent reward to risk (incorporating all support and resistances is a scalping method).
Their take profit level could be aimed at resistance of 1 time frame higher, for example. In that process, the Forex trader is, in fact, ignoring lower time frame resistance, as there is the expectation that price will break through that level at one point or another (even after it creates a retrace).
Setting Your Risk to Reward Ratio
The higher reward to risk a trader aims for, the less likely the chances are of that trade hitting target. The lower the reward to risk a trader aims for, the more likely the chances are of that trade hitting target.
The reason why the above is always prevalent can be explained by the paragraph above. When aiming for a higher R:R, a Forex trader is assuming that certain support and resistance levels will eventually break. The higher risk to reward ratio (R:R) means that price needs to break through more layers of support and resistance and therefore the odds of success diminish. Whatever set of parameters a Forex trader chooses, all of us must ensure that the relationship between the odds of success and reward to risk translate into profitability.
Timing Your Positions & Exits
When price pushes through a support or resistance level, then price is, in fact, breaking out of a consolidation zone. The break out usually lasts for a while but then undoubtedly a retracement will settle in because Forex traders want to buy on dips and sell on rallies, no matter what time frame.
If price does not hit your take profit level during this breakout momentum, then your trade is going to witness and experience a retracement. When the retracements takes lots of time in its development and a Forex trader does not see an immediate continuation, then the likelihood of a retracement taking place on 1 time frame higher is increasing.
How do we know what is a lot of time? Anytime there is no break of the high or low within 5 to 10 candles increases the likelihood of a bigger retracement. The reason is simple: if the candle highs and lows are not broken, then that particular impulsive break out could be at its end and price will slide back into a consolidation or retracement.
Hopefully, a Forex trader has already booked profit before price slides into a corrective pattern like that. If your target is not hit, then a retracement on a higher time frame will commence. The trade would need to survive this period of uncertainty and find continuation when sufficient pullback has been made. The second impulsive break could then bring price to target.
STOP LOSS SURVIVAL
The question of whether a trade can manage to survive the retracement and consolidation, and whether a trader can join enjoy the next impulsive break out (hopefully in their direction) is dependent on two elements:
1) Deepness of pullback / type of consolidation (traders have no impact)
2) Tight or loose stop loss (traders can influence)
Obviously, the deepness of the pullback and type of consolidation will influence whether the stop loss gets hit upon the retracement. A shallow pullback will not touch the stop loss, a deep pullback would. The type of consolidation or retracement formation, however, is not an element that a Forex trader can influence.
Therefore, extremely crucial in that process is where the stop loss is placed. The key is the following:
1) If the stop loss is placed halfway a swing high swing low of 1-time frame higher, then the stop loss is in danger of being taken out.
2) If the stop loss is placed below a swing high swing low of 1-time frame higher, then the stop loss is relatively safe and any normal pullback would not stop out the trade (only if an even bigger reversal is taking place).
Conclusion - How to Set Stop Losses in Forex
1) There is nothing wrong with using tight stop losses BUT Forex traders must be aware that closing the trade during the first impulsive break out (on the time frame of entry) is vital to enhance the reward side and reduce the risk of a retracement of 1-time frame higher taking out the stop loss.
2) If the take profit has not been hit before the retracement and consolidation zone starts, then the Forex trader must check whether the (tight) stop losses is underneath the swing high swing low of 1-time frame higher.
- If yes, the trade can be kept on the table, because the Stop Loss will not be triggered by a normal retracement for more continuation.
- If not, the trade should be closed or moved to break even, because the Stop Loss is in serious danger of being triggered by a normal retracement for more continuation.
This guide might help you with understanding why some trades ultimately fail after a good start. I hope it does. If you want more guidance on optimizing trail stops and knowing where a stop loss is safe or not, join our live trading room!
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