Setting stop-loss orders whenever you open a trade is an essential risk management technique. With stops, you limit your losses in case the market crashes against you.
However, an SL order would do you more harm than good if you failed to set it properly. Here are the four gravest SL placing mistakes that could harm your capital.
Using a stop-loss order doesn't necessarily mean you accept that your position will run at a loss. A stop-loss order is all about protecting against adverse losses when the market goes against you.
You don't want to be a coward who sets a stop too tight and misses out on potentially profitable opportunities because you don't give the market enough breathing room.
Remember, the forex market is volatile. It has this interesting nature of having a short-term fluctuation before continuing to its primary trend.
If your order got triggered during that short-term fluctuation and your trade direction happened to follow the primary trend, you just wasted your time, investment, and transaction fees.
When setting an SL order, always look at the pair's volatility to ensure an adequate level for stop. Never let fear and panic take over your decision-making; these emotions may hinder you from raking in those sweet profits.
Mike is on a losing streak, and these losses cost him half of his capital. He learned his lesson and decided to set up an SL order.
After analyzing the market and the news, Mike decided to go long EUR/USD at 1.1100 with an SL order set at 1.1090. He's only willing to risk 10 pips for this trade.
Upon entering the trade, the market fluctuates, and it starts its downtrend. From 1.1100, the market is now at 1.1093, which is 3 pips away from Mike's stop level. As expected, it fell to 1.1090, which liquidates Mike's trade.
However, after a few minutes, the market reverses and goes up to 80 pips, putting the market at 1.1170.
This significant price movement represents a missed opportunity for Mike, as he could have captured a profit of 70 pips if his position had remained open.
So, what does this tell you?
Give enough breathing room for your position to withstand market fluctuation.
Okay, it's a mistake to set your stop too tight.
So, should you set it too wide? No.
What you want is to set your stop level adequately—not too tight, not too wide. While a tight stop denies your position a chance to withstand price fluctuation, a wide stop subjects you to higher risk—which may ruin your risk appetite.
Note: By wide stops, we mean more than a 100-pip difference from the entry price.
Also, using a wide stop level defeats the purpose of placing an SL order at all. The market may not move in your favor unless you're willing to wait and have sufficient account equity to support floating losses.
But is "too wide" and "too tight" a bit subjective? How do you confirm whether your stop is wide or tight?
Well, you can use technical indicators like support and resistance.
Support/Resistance indicators are your best friend when setting a stop-loss order. Essentially, it's only rational to place a buy SL order below the support level; likewise, a sell order above the resistance level.
This way, you gave your position enough safety net to face market volatility while having a reasonable stop level to mitigate market risk and manage potential losses.
Why?
When you set an SL order below the support level (if going long) or above the resistance level (if going short), you give your position enough space to play along with market fluctuation. This way, you combat the unfortunate situation of missing out on profits while still enjoying protection from your order.
Your position size has no role in determining your stop level. Why? Your sizing has nothing to do with market behavior.
When you're trading, your focus should be the market dynamic. So, just as you'd want to base your entry and exit on the market trend, your stop level must also depend on the market.
It simply means you have a trading plan if you set an SL order. Essentially, you have a predetermined price point for exiting a losing trade.
With an SL order, you can have peace of mind knowing that your losses won't be too big, which may damage your trading account.
Also, I'm sure you've got the impression that you always watch the market closely and efficiently.
But what if you've got to do your day job? What if the market spikes SO hard within a second? Do you just accept that you're about to lose money and blow out your account?
Absolutely not. Setting a stop-loss order can be an effective risk management strategy to avoid losing your money rapidly and further.
Throughout the past lesson, you've learned the nitty-gritty of stop-loss order and the best practices to maximize it. For the next module, you'll dive into position sizing and the important consideration when deciding the size of your trade.