How do I know where to place my stop loss on a forex trade?

Question:

How do I know where to place my stop loss on a forex trade?

Answer:

Kathy Lien, Director of Currency Research, GFT

I am so glad you are asking this question, because the number one rule of trading is “always use a stop.” This is particularly true when trading forex, because trends can last longer than many traders anticipate. There are many different ways to place a stop loss, but the three most popular types of stops are:

1. Technical stop
2. Volatility stop
3. Equity stop.

Technical Stop – If you enter for a technical reason, you should exit for a technical reason.

Most currency traders enter their positions for technical reasons, so the proper exit should, theoretically, also be based on a technical indicator.  Say you bought the EUR/USD because of a moving average crossover – the proper time to exit would be when the moving averages cross again.

Not all traders have the patience to keep a trade until the technical setup invalidates, though, because that usually occurs after the trade has given up some profits. More commonly, forex traders will use technical indicators to help determine support and resistance levels. Moving averages work well in this way, as do other indicators, such as Fibonacci retracement levels.

If you are not familiar with technical indicators, you may want to place your stops near psychological levels, because moves tend to pause around those points. For example, if you were long the AUD/USD from 0.9025, there is a good chance that 0.9000 will be an important support level. In that case, you may want to place your stop slightly below that level.

Using standard technical indicators, like moving averages, as stops basically creates a trailing stop – your stop moves as the currency pair moves. A trailing stop can help you to lock in profits as the trade moves in your favour. However, it also requires a bit of work because in most cases, you have to manually adjust the stop.

Volatility Stop – Use the right stop for the right currency.

When thinking about where to place a stop, it is important to know that some currency pairs have larger intraday ranges than others. When placing a stop, you should consider the volatility of the currency pair. For example, the average daily trading range of EUR/GBP is approximately 90 pips, while the average range of GBP/JPY is closer to 255 pips. This means that a stop of 30 pips in EUR/GBP is far more significant than a 30-pip stop in GBP/JPY. In fact, for GBP/JPY, a 30-pip stop is nothing more than hiccup in the currency, but for EUR/GBP it may actually represent a change in the short term trend.

There are many different ways to determine whether a wider or tighter stop is suitable for your trade. One way is to gauge the width of the swings by looking at an intraday price chart of the currency pair. Another way is to use the Average True Range (ATR). For currency pairs with high ATRs, you should use wider stops, while currency pairs with smaller ATRs may require tighter stops.

Equity Stop – A set amount that you are willing to lose.

Some traders may want to use an equity stop, which basically caps your loss at a set amount of money. For example, you may decide that regardless of what happens, you are not willing to lose more than one percent of your account on any one trade. Therefore, if you are holding 100,000 units of Australian dollars against the U.S. dollar, your stop should be $1,000, or approximately 100 pips. This type of stop is suitable for investors or traders who are not particularly familiar with technical analysis or are not interested in changing their stop on a regular basis.

One more thing to consider: time.

One final element to consider when thinking about where to place your stop is time. Similar to share trading, shorter-term forex traders may not be interested in holding positions overnight. The forex market trades on a 24-hour basis, so a lot of volatility can occur while you are dozing off – particularly since the U.S. session trades when most Australians are hitting the sack. Unless you are willing to bear the risk of overnight volatility, you may want to consider closing your trades or stopping yourself out before your day ends.

If you are a longer-term trader, holding positions overnight may not be a problem, particularly if you are hoping to capitalise on a news report that may be released during the NY trading session.

Forex traders should also think twice about holding positions when the forex markets are closed over the weekend. This is not a major problem if there are no scheduled events. However, if there are any special meetings by central bankers or other policymakers, it may be smart to close your position as a major announcement will inevitably cause a gap open.