A very important parameter in the management of trading risk is the setting of limits that will indicate the exit price from trading if the price moves against the estimated trend. To be precise, we are looking for a way to limit losses or protect profits, that is, the way in which the stop loss is defined. Stop-loss order is a fundamental order that, however, involves many interpretations.
The tricky problem with the stop-loss order is that it should not be so small as to take the trader out from trade but on the other hand, it should not be so big as to create large losses or redemption of the profits made, at a wrong level and time. The solution is to find an approach that is a balance between the two and will be based on market dynamics.
The stop loss strategy should be designed in such a way as to allow a trade to breathe and fluctuating with the normal fall and market flow. To create this strategy, a trader should choose different types of stop-loss orders when different cases appear or to combine these orders. There are a variety of stops that a trader can incorporate into a strategy.
The following orders are the ones which they are considered as the most valuable to create a stop loss strategy:
As a first step, the initial stop-loss order must be defined, which is the first stop set at the beginning of a trade. This stop is determined before a trader enters a trade. The initial stop order is very important because as explained in a previous article is this one that is also used to calculate the position size. It is the largest loss a trader is willing to take when it gets in a trade.
This order is shaped according to how the market is evolving. The order allows the trader to lock in his profits as the market moves in his favor. In fact, the trader does not stay in his initial stop-loss order since the order is moved according to the trend. Thus, since the initial stop order has changed, when the price comes against the current trend, the new changed stop-loss order is activated, and thus the trader locks his profit as leaves from the trade.
Three-bar trailing stop
When a price has developed a current trend and moves with three different bars in a row against that trend, then the market seems to be losing momentum and so a reversal of the trend is expected. So, when there is such kind of behavior a good strategy in order to protect and lock the profits made, it is as there is the three-bar reversal of the trend, the stop-loss order to be activated.
One-bar trailing stop
This order is used by a trader when prices have reached the target profit area. Then, if the price goes against the trend by one bar a trader locks the profits and leaves the trade. It can also be used when there is a break-away market, and a trader wants to lock in the profits immediately. It is also used after three to five price bars that move strongly in favor of a trader.
Trend line stop
This is a very common stop-loss order and is activated when the price breaks a trend line. That is if the price goes below the low in an uptrend or if it goes at the top of the high in a downtrend. In fact, a trader leaves the trade when the prices close on the opposite side of the trend line.
There are also other ways of defining the stop-loss orders which however mostly, are derivatives of the abovementioned.
Setting stop orders also require a certain level of good judgment that the trader should have, which is usually based on his experience and character. It is important for the trader, when setting the stop orders, to consider his psychology in the sense of how comfortable feels when setting the limits of the price movement which will activate the stop order.
Traders should try to tame their fears and set the stops at reasonable market levels. This is done when stops are setting in relation to market activity. Volatility indicators that indicate market price activity is a good approach to determine the level of a stop order. These indicators help traders not to choose an arbitrary place to set the stop order. Improper setting of the stop it costs both psychologically and financially as the stop-loss orders are at the heart of trading activity, especially for the short-term traders. This is why, setting stop-loss orders deserves a lot of attention and study.
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