5 Proven Stop Loss Techniques for Forex Trading Success

Stop Loss is an important tool for all types of traders, including those in the Forex market. It's a resource for containing risk, managing it in some way, and limiting potential capital losses. It's a tool not to be overlooked. The risk is both economic and psychological: if you lose control of your trading, you lose control of your money, and the sense of uncertainty increases. In this article, we discuss Stop Loss, clarifying its meaning and describing some of the most common techniques for setting it up properly.

What is Stop Loss and why is it important

The definition of Stop Loss is very intuitive. This term indicates the price level at which the trader, automatically or not, exits the market. It's essentially the price level that signals that a losing trade is no longer recoverable, at least not in the short term. From this simple definition, the true utility of Stop Loss and its reason for being is understood: to limit losses. Its use presupposes a moral quality, which beginners - precisely those individuals most at risk - often lack: the ability to accept defeat, to understand one's failure, obviously limited to that single trade. Stop Loss, therefore, can be compared to a strategic retreat. It's evident that, in its use, reason prevails over sentiment, determination, and ambition. It's the result of a (always prior) calculation of costs vs. benefits. Setting a Stop Loss means admitting, even from an operational point of view, that the trade has a good chance of ending in a loss. This awareness must accompany all trading activities and marks the transition from the status of an absolute beginner to that of a "sufficiently" mature trader. Understanding the true meaning of Stop Loss, however, is not the only obstacle to its correct use. On the contrary, the most complicated part comes immediately after, that is, when setting it. It's not at all simple to identify that price level that signals that the trader is no longer recoverable. Also because there are many methods to achieve this goal. Here are some particularly widespread ones.

Percentage-based Stop Loss

This is the simplest method of all, which involves a purely mathematical calculation, which however rests on arbitrary bases and does not take into account some important elements. But let's take it step by step: the "Stop Loss" percentage method consists of identifying the correct price level starting from a given fact: that is, from the maximum tolerable loss of capital. The reference point is the capital present in the account. A reasonable percentage could be 0.5%. Under these conditions, the Stop Loss corresponds to the price that has already generated a loss of 0.5% of the account. Obviously, any desired percentage can be decided. This is precisely where the arbitrariness arises. The calculation mechanism is simple. You take the percentage, find the corresponding value in absolute terms (simply by calculating it on the total capital), translate everything into pips, and add/subtract it from the price. Simple, right? Too bad the method doesn't hide significant effectiveness. The problem with this method, in addition to the arbitrariness of the percentage, consists of a trivial fact: it does not consider the concept of a "trade that is no longer recoverable". In general, the Stop Loss could be reached either too late or too early. That is, when the trade has already caused significant damage or when the trade still has a hope of producing profits. Simply put, the percentage method completely ignores the market and does not take into account any evidence from technical analysis. Therefore, think very carefully before using this method, as it could prove counterproductive. However, it can be said that it is suitable in at least one case, that is, when the market situation is so chaotic as to make technical analysis incredibly uncertain.

Stop Loss with pivot points

This is the most used method of all. Very simply, it involves setting the Stop Loss at the level of pivot points, i.e., supports and resistances. Specifically, the Stop Loss is set on the resistance if the trade is short (you are selling) and on the support if the trade is long (you are buying). The dynamics have a strict logic: if a resistance is broken, it means that the asset confirms or begins an upward trend; if a support is broken, it means that the asset confirms and begins a downward trend. The advantage of this system is its reliability. It takes into account solid technical evidence. It's clear that if the price exceeds a resistance, it's very unlikely that there will be a change of course in the short term, and the same applies to support (in the same and opposite direction, of course). However, this method also has its criticalities. In fact, it is also a bit arbitrary. Much less arbitrary than the percentage method, let's be clear, but a bit arbitrary nonetheless. In particular, because there is not just one support or one resistance, so it's up to the trader to decide whether to choose pivot points close to or far from the price. This difficulty is mitigated, however, if another factor is inserted, namely the maximum sustainable loss. If these elements are combined, that is, if pivot points in line with one's possibilities are considered, this method is undoubtedly a winning one. However, experience is still needed to be able to master it to the fullest.

Stop Loss with lows and highs

The method is similar to the previous one. If we want, it represents a sub-type, a variant of it. Fortunately, a very simple variant that leaves little room for the exercise of free will. Let's be clear, it is not necessarily a more effective method. It's just a lot more cautious. For this reason, it is often adopted by beginners, i.e., by those who do not yet feel able to develop an in-depth technical analysis, the same that generally precedes the identification of the Stop Loss with pivot points (or other methods that we will see later). What does the lows and highs method consist of? Very simply, it involves setting the Stop Loss a few pips beyond the lows and highs. In this perspective, they are considered as pivot points. Here too, however, the same doubt risks arising. There are many lows and highs (session, weekly, monthly), so which ones to choose? There are two opportunities: identify them based on the time horizon of the trade itself; choose those closest to the entry price. The second alternative is the most adopted as it is the simplest. Above all, it is the most prudent. The fact that it is the most prudent, however, does not give rise to zero risk (which does not exist in trading). On the contrary, by virtue of this method, some drifts appear more probable than in other cases. For example, that in the end the Stop Loss is really tight and that when it is reached, the trade is still recoverable. Notwithstanding that, at least according to the fundamentals of technical analysis, a low or a high always represents an important price capable of offering reliable signals.

Stop Loss with volatility

This is a rather complicated method. If nothing else, because it takes into consideration a technical analysis indicator and places it at the center of the Stop Loss identification process. What does this method consist of? At a theoretical level, there is nothing incomprehensible or ambiguous: the Stop Loss is placed just after the price range drawn by the oscillations. In simple terms, it means positioning the Stop Loss "beyond" the volatility. Obviously, just a little beyond, just a handful of pips. The basic principle is more than logical. If a price remains within the "physiological" oscillations for that given period, then the price can change its course in the short term, making the trade always recoverable. Therefore, since the Stop Loss allows exiting the market when the situation is no longer recoverable, it is obvious that the price level must be set outside the physiological volatility. However, a problem remains: how do you define volatility? How do you draw the range? By eye, it is simply not possible to understand it. Technical analysis must be used. Ultimately, therefore, this method makes use of indicators. The most effective one is represented by the Bollinger Bands. In that case, it is sufficient to place the Stop Loss beyond the Bollinger Bands themselves. Based on what has been said up to this point, this method seems to have no flaws: it intervenes when the trade is truly not recoverable, it is corroborated by technical analysis. There is a but: it is really difficult to practice. First of all, it is necessary not only to know how to read but also to correctly set the indicator (and it is not certain that everyone is capable of doing so). Secondly, it is necessary to know how to distinguish false signals and avoid false interpretations. Unfortunately, when technical analysis is involved, it is a risk that must be faced and considered almost physiological. The solution exists: use other indicators as a countercheck. In this case, however, the process of identifying the Stop Loss would become quite cumbersome.

Dynamic Stop Loss

This method is also called "Trailing Stop". It is also the name of the level itself. It is a very particular variant of the Stop Loss, as it partly revolutionizes its concepts. It is no longer a static level, a boundary equal to itself that must not be crossed, under penalty of catastrophe. It is instead a mobile level, which moves according to market conditions. Hence the reference to dynamism, also present in the term trailing. Today, when specific conditions are met, the Trailing Stop is considered the safest, most realistic, and reliable method. The reason is simple: the market often changes face, moreover in an unpredictable way. This often happens when external factors intervene, those typical of fundamental analysis. If the market changes, it is clear that the evidence gathered some time before, during the trade planning phase, risks becoming obsolete. What does the Trailing Stop method consist of? In simple terms, in the automatic movement of the Stop Loss when the price reaches specific pivot points or points capable of acting as such (e.g., lows and highs). Here too, of course, we are in the field of preventive programming. An approach, this, that can never be set aside. When is the Trailing Stop really useful? Assuming that it always is, it manifests an even more significant utility if the trade has a broad time horizon. In that case, in fact, price movements often degenerate from "caused by physiological volatility" to "conquest of pivot points". In short, the changes are less temporary. The Trailing Stop is therefore the preferred method of those who do Swing Trading or simply long-term trading.