What is a stop loss and why do we need it?

Stop Loss is an automatic order that closes our trade once the price reaches a specific level. Usually, when opening an order, we have the option to enter our stop loss level.

There are 2 types, if we place a sell order, we must place a stop loss at some distance above our entry price. If we place a buy order, we must place a stop loss some distance below our entry price. For example, let’s say that in EURUSD the price is at 1.22432 and we want to sell, if we want a stop loss of 20 pips. We place it at 1.22632.

Using a stop loss in this way is a method of risking only a small amount, typically between 1% and 5% of our total trading capital per trade. And therefore we also limit losses on our account, which gives us peace of mind when trading. The most important part of trading is psychology, or put another way, it’s about how you react to that price when it triggers your signal. Or put another way, it will affect your performance as a trader.

When I trade, I usually risk around 20 pips per trade. This means that if I am trading at £1 per pip then my risk is £20 and it means that I would need a total bankroll of £400 if I wanted to feel comfortable taking that trade. I wouldn’t feel comfortable if I was risking more than that and if I don’t feel comfortable it will affect my trading actions. For example, I could be hesitant and late, or if I see a profit but I’m afraid of taking a profit, but this could stifle a really good trade. So, as we realize that getting a stop loss at a level that we are comfortable with is very important to your psychology, which will generally affect your trading decisions, which will affect your performance. Just like any sport in that respect.

I have often heard it said that “a true professional trader doesn’t care if he wins or loses”. Well, this is true because he knows that his trading method will most likely lead to long-term profits. The important thing is how many trades we win compared to how many we lose and we will only know over time. So whether you win or lose, whether you’re a true professional, it just doesn’t matter on any particular day. It’s when we’ve been losing for many months that tells us we’re not doing well and need to reevaluate things.

BUT don’t rely solely on stop loss techniques to make your system profitable!

It’s a subject of much debate, I’m sure how exactly a stop is used and I’m sure there are more books and websites that give a lot of scope on this topic, but as far as I see a true long term profitable trading system though I would say that you need a stop loss and it is very important. You shouldn’t rely on a stop loss technique to be profitable as I’m sure it won’t work in the long run as these types of systems usually end up wiping out all your capital when things go wrong.

A good trading system needs to be in the right direction most of the time, otherwise it is based on the stop method which is not the path to long-term profitable trading in my opinion. Let’s take roulette as an example. Now, I am a fan of online roulette, but I can tell you from experience that there is no system that can beat roulette no matter what you do. There are over 7,000 roulette systems that I have heard of. Of them there will be variations of those that are based on a betting method called Martingale. Let me briefly explain:

Martingale basically aims to win back a loss by doubling the next bet. The appeal is strong and rightly so, as it seems like you can’t lose, but you can. He will see that eventually a long losing streak will deplete the player’s risk capital. If he watches the roulette player in the short term, it will appear that he is doing well, but if he watches his game for many months, it is very likely that he has lost all his risk capital at some point.

Example:

£100 scale

Bet €1 on Red it Loses Balance = €99

Bet £2 on Red it Wins Balance = £101

Bet £1 on Red it Wins Balance = £102

Bet €1 on Red it Loses Balance = €101

Bet £2 on Red it Loses Balance = £99

Bet £4 on Red it Loses Balance = £95

Bet £8 on Red it Loses Balance = £87

Bet £16 on Red it Loses Balance = £71

Bet £32 on Red it Loses Balance = £39

Bet £64 on Red it Loses Balance = £39

You can’t place any more bets and there’s no way you can get up to £103 back so you’ve lost

This is an example of relying on a flawed money management strategy to win and not relying on a solid system. Because you just can’t get information or anything that gives you an advantage over a number. If we make flat bets on roulette, the casino advantage will also slowly decrease our balance. Quite simply, you can only rely on luck to make a profit here.

If we take the stock market, although it has elements of predictability, it is not fixed odds betting, the chances of the price moving in or out of your favor change all the time. Yes, it can be difficult, but a good system can do it well; Otherwise, there would be no profitable traders in the long run, and I can assure you that there are.

Some of the best known stop loss methods I know of:

final stop

This is where the stop level moves along with the price to a predefined level set by the trader. For example, let’s say the price is 1.22432 and we want to sell, so we place our stop at 1.22632. Now, if the price goes down to 1.22332, our stop will also be left behind and moved to 1.22532 without any trader intervention. Now, if the price moves against us, the stop will remain at 1.22532, which will in effect protect us from a bigger loss if we leave it at 1.22632.

Although this method has its pros and cons.

Pro’s = Minimize losses

Cons = Does not allow your trade to breathe and therefore decreases some potential good moves.

But it all depends on the type of system you use. I think it’s not bad if your system predicts outbreaks.

Cover costs

When the price moves in profit by a certain amount set by the trader, the stop loss moves from the stop loss level to the entry price, thus protecting the trader from any loss.

For example, let’s say the price is 1.22432 and we want to sell, so we place our stop at 1.22632. If we think we should move, stop to break even when we have a profit of 20 pips. When the price reaches 1.22232, the stop is moved from 1.22632 to 1.22432, our entry level.

I find this type of stop loss method good for swing trading or when your system plans to hold the trade for a day for a good trend.

Although this method has its pros and cons.

Advantages = Allows you to keep your trade as long as you believe the price will move in your favor.

Cons = As the markets fluctuate, you can sometimes stall out and lose profit.

It all depends on how the market behaves, and I believe that this method is based on additional judgment of the behavior of the markets.

50% lock

This method involves firstly allowing the trade to breathe and is therefore suitable to hold the trade for a day or two and block half of what is there. It’s good because it allows our trade to breathe and is in line with the golden rule of holding on to winners.

Normally I would change this like this:

I would place a buy order at 8am, let’s say EURUSD at 1.22432 with a 20 pip stop loss at 1.22232. I come back at 12:00 pm and see that the price is now at 1.23032, which means that I have a profit of 60 pips. Therefore, I would move my stop to a 50% level at 1.22732, so now I know that I profited no matter what, but still have a chance to take more profit if the price goes higher.

stop reverse

This is when we place an opposing order at a stop loss level. This is an effective method to counter when you make a mistake in the operation. It works like this, you would enter a buy order on the EURUSD at 1.22432 with a 20 pip stop loss at 1.22232 but you would also place an opposite version of that sell order at this stop loss level of 1.22232.

My personal favorite is holding out for days while major spikes stop

With my system you may only be risking 20 pips, but every 3-4 trades you will see profits of 100+ pips because my favorite is 50% lock with a slight difference. Instead of looking at the 50% level, I look at previous major price spikes and place my stop at these levels. Price spikes give a better idea of ​​the true direction of the market, so what better way to hold on to that direction than to use price spikes, as even though the price fluctuates, if for example it is shorting then the price is not it should rise above previous peaks until there is a big change in direction.

What is the ratio of the profit factor to your ideal risk/reward ratio?

I have seen many trading systems and they all look great on paper but there is one thing they never show and it is up to you to find your being. It is the Profit Factor Ratio or PFR. This is where you find the relationship between your profits and your losses. If in many trades it is still above 1, then your system is profitable. This main point is what all trading systems don’t really show you, but it’s what you need to be a true trader.

profitable trader.

There was 1 system that I remember in particular that I guess stuck with me and is what led me to the goal of holding a trade for a few days for maximum profit while only risking a small amount. Obviously, I can’t name names here, but the main promise was that most trades take profits of 100+ pips by lunch time. Now, like all systems you read about, they always show you the good while glossing over the bad. What they don’t show you is the reality of how that system works. You can only see the reality after you have bought the system and experienced trading for yourself.

Therefore, we need to backtest and find the true PFR of the systems.

From experience, my trades usually end up with a risk reward of 1 to 4, which means that for every £1 invested, I expect a return of £4 if that trade wins. This statement is irrelevant, what really matters is the profit factor ratio. Or just your profit/loss. If it is above 1, then you are in profit. It depends on how high it is above 1 as to how fast we can make profit and how much we can make on profit. So when I trade I always check that my system is working and make sure the PFR is > 1.

For example, let’s say I placed 1000 trades with a strike rate of 1 in 4, and each winning trade earned £20 while a losing trade generated £5. We can expect 250 winners and 750 losers. Sounds bad at first, 750 losers Oh no! goal clock:

250 winners at £20 per win = £5000

750 losers at £5 per loss = £3,750

So,

Profit / Loss = PFR

5000 / 3750 = 1.33

Our PFR is 1.33, so I would say a realistic PFR. Trading at £1 per pip means that we will make a profit of £1,250 on 1,000 trades made. £1250 of profit on a £100 investment is great potential to make money. Of course this is a conservative PFR, there are many systems out there with a higher PFR. I’ve read that realistically most systems hit a little less than 2.0. Mine is 1.33, I can live with that.