Where to place stop losses in Forex

Managing risk is one of the most important factors when it comes to successful trading. Risk management simply minimises the amount of money you lose. There are many ways in which you can do this. In this article, we are going to focus on using stop losses. Specifically, we’re going to explore where to place stop losses.

Reducing your risk

You should know that the following advice stems from my own experiences. There are many other techniques and systems online – but whatever you decide to follow, ensure you have proof of the concept’s effectiveness.

I have two main methods to ensure simple and consistent placing of stop losses. The first is an approach for long-term trading (days to weeks), which plays out in line with the fundamental picture. The second is an approach for short-term trading (hours to days), which is more technical in nature.

Long-term trading

For longer term trades, I use price levels that are psychologically significant to the markets. The reasons why a price level is psychologically significant can vary. But generally, these price levels cause traders to take action.

For example, a round number such as 1.1000 will get traders’ attention.

Many expert commentators and analysts publish key price levels which the markets are likely to react to. To acquire the most reliable price levels, I suggest you look at the central banks. Monetary policy guidance documents often list noteworthy price levels.

In addition, I pay attention to common levels publicised in the financial press.

Short-term trading

For shorter term trading, the process for placing stop losses is a little more technical in nature.

If you are using a candlestick chart, you should notice that specific price patterns play out regularly as prices move up and down.

Traders call these patterns ‘swing highs and swing lows’ or ‘swing points’. These are turning points in the market. In other words, price was moving in one direction and then stopped to move in the opposite direction. Traders refer to this pattern as a ‘swing point’.

This is useful because it highlights areas where you can place your stop loss order.

Using swing points

Imagine for a moment that your trade idea to buy a currency pair is correct.

The last time the market sold off, it stopped at a certain price, then reversed to carry on going up. If your analysis is correct and the market is focused on buying this pair, it is unlikely that the price will fall below the most recent swing point, before continuing higher.

Why? There is recent evidence that the market views the level as a good price to buy. It’s a level the market as a whole is aware of.

It’s important to note that this swing point will mean nothing when the markets decide they no longer want to trade in that direction. It is the same if something changes to cause a sudden reversal in sentiment.

For this strategy to be effective, it’s vital that you tune into the current market sentiment. You also need to understand which way it is most likely to drive the pair that you are trading.

Placing your stop losses

With this in mind, you should place your stop loss just below a ‘swing low’ (when buying) or just above a ‘swing high’ (when selling).

This simple method works incredibly well. It’s what I do in my own trades.

However, there is another important factor to be aware of when using swing points. Other professional traders are aware of ‘swing points’ – and some attempt to use it to their advantage.

It’s known as ‘liquidity hunting’. It involves traders deliberately placing large trades at times when there is likely to be a high volume of buy or sell orders. Levels above and below swing points tend to generate a lot of market liquidity.

This means professional traders can get a better ‘price’ for placing high volume trades. This can occasionally impact on the price of a financial instrument.

Beware of liquidity hunting

However, there is another important factor to be aware of when using swing points. Other professional traders are aware of ‘swing points’ – and some attempt to use it to their advantage.

The Forex industry calls this ‘liquidity hunting’. It involves traders deliberately placing large trades at times when there is likely to be a high volume of buy or sell orders. Levels above and below swing points tend to generate a lot of market liquidity.

This means professional traders can get a better ‘price’ for placing high volume trades. It can occasionally cause retail traders to be stopped out of their trade.

Let’s consider an example:

Cumulatively, the market is backing EUR/USD to increase in value in today’s session. As such, it’s an excellent pair to buy.

Most retail traders place their stop losses close to the recent ‘swing low’ price level. Remember, these stop losses are sell orders.

This potentially high volume of sell orders solves a problem for professional traders looking to place a significant buy order by increasing liquidity. Keep in mind, an increase in liquidity makes placing big trades more affordable for professional traders.

By placing large sell orders, professional traders can push the market lower, triggering the large pool of stop loss orders. At this point, professional traders reverse their trade and execute the original buy order. The net effect is that professional traders ride the move, while many retail traders find themselves stopped out.

To avoid this happening in your trades there is a simple solution. Just utilise the second most recent swing point, rather than the most recent. Doing so will protect your capital if the market moves against you – and prevent you from being exposed to liquidity hunters.

I hope you’ve found this article useful. If you have any questions, please leave them in the comments below. I’ll try to reply to as many as I can.

 

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