Talking Points:
- Traders will often base trading decisions on their accounts instead of on the needs of the markets
- We want to align the market’s need and the needs of our account.
- We want to reduce our stop when the market gives its go-ahead, thus showing a simple yet powerful way of reducing risk based on breakouts.
While it’s usually good to reduce the risk on a position, it’s easy for new traders to get overprotective and reduce the stop loss as soon as the position starts to gain. Yet if there is no clear technical or fundamental reason, we would probably be better off leaving the stop at the original level.
Other traders will consistently trade with a 20 pips stop loss as it is the only amount of drawdown that their account will allow before they get into trouble. The issue in both of these examples is that trading decisions are based on the equity of the account and not on the markets. The same holds true for the trader that only books gains after he has accumulated a certain percentage return or a certain amount of pips.
What they are forgetting is that the market does not care about the individual trader, but rather only cares about discovering the next price equilibrium, a level where demand and supply will be equal, or in trader terms, support/resistance. The search for the next price equilibrium can take price substantially higher or lower than our entry. Trading should therefore be based foremost on the markets. If the market conditions meet the demand of our account, we can trade.
We want to align the markets needs and the needs of our account.
| Then when is it ok to reduce the stop? | |
|---|---|
The initial stop loss on such a trade could be the nearest major swing low on the chart. The reason for this is because as long as the price remains above this level, the trend will be bullish, and in a bullish trend, we want to be long. If the price trades under the swing low, the trend will not be bullish, and we do not want to be long in a market that is not bullish. See figure 1. As the price trades higher, it will be tempting to reduce the stop to reduce the risk, yet with an entry on a breakout, the entry will usually be in the middle of the short term trading range. Hence reducing the stop to breakeven at this point in time will make little sense. | |
For us to reduce the stop loss in a way that reflects the true nature of the definition of an uptrend, we need a new higher low, and we would place our stop loss just under the newly created higher low. How are new lows confirmed? A new low is confirmed if we get a new breakout in line with the trend. Hence the same type of signal that got us into the market initially. Figure 2 shows a new breakout after a shallow pullback in price. We can place our stop loss under this newly created low after we get the breakout, not before. Figure 2: Charts created using Marketscope – prepared by Alejandro Zambrano | |
As we spend more time in front of the screens, we start to pick up these breakouts naturally, and our job as traders is to make sure that we focus on the breakouts and lows that matter for our time frame and investment horizon. If we combine the charts above into one chart, we get figure 3, as seen below. At this point we can see that original entry level and the new stop loss level is more or less the same. It is at this point that we would be having our risk reduced to zero as the entry and the new low are more or less at the same level. We would also stay true to the market because if this is a genuine uptrend, then there is no reason for price to trade under the newly created low. Suggested Reading - Benefits of Trend Trading Figure 3 | |
| Charts created using Marketscope – prepared by Alejandro Zambrano |
Testing a new strategy is preferably done in a safe environment – test this strategy using a practice account.
Suggested Reading: Using Price Action to Catch Swings in the Forex Market
---Written by Alejandro Zambrano, FX Analyst.
To contact Alejandro, tweet him on @AlexFX00
Alejandro hosts our London session outlook webinar every day at 9:30 AM London time. He also hosts educational seminars in London each month, and you could join him for an evening seminar or morning seminar, where he shows you how to setup trading ideas before the London session kicks off. E-mail him at azambrano@dailyfx.com for more info.
