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How Do I Know If a Stop Is Too Big?

How Do I Know If a Stop Is Too Big?

Richard Krivo, Trading Instructor

As we evaluate various trade set ups each day in the live trading webinars, a key element in each trading plan is to determine where a trader would best place their stop.

There are two elements at play here: 1) looking at the chart, where should the stop be placed based on price action; and, 2) can the trading account handle the amount of risk taken on by the size of the stop.

Each one of these is critically important.

As far as stop placement is concerned, a general rule of thumb goes that in a downtrend the stop would be placed above the previous high. Take a look at the chart below for a visual…

How_Do_I_Know_If_a_Stop_Is_Too_Big_body_chart_6_24_11.png, How Do I Know If a Stop Is Too Big?

So, if the trader sells (shorts) this pair on break of support which is represented by the gray line, the most prudent stop placement would be just above the previous high where the word “Stop” can be seen. (If the pair were in an uptrend the opposite would be true. The stop would go below the previous low after a break of resistance.)

OK…we have now taken care of step #1 above. Let’s move on to point #2…

A trader who enters this trade will be taking on about 225 pips of risk since the stop is roughly 225 pips from the entry. The question now becomes can the account handle 225 pips of risk without being overleveraged.

Our Money Management rule is that a trader should never place more than 5% of their trading account at risk at any one time. So how can a trader make that determination?

Here are two ways to go about it…

After the size of the stop is determined, divide that number by .05. That will provide the size of the account that will be needed to take on that size stop without compromising the 5% rule. So, in the case of the 225 pip stop above, when we divide 225 by .05 we get 4500. That means one would need a trading account of at least $4500 to take on this trade and not put more than 5% of the account at risk should the stop be triggered. If the trading account is below that amount we would advise not taking the trade.

Another way to make the above determination is to simply calculate 5% of the size of the account. Then as a trader goes searching for a trade, they know at the outset exactly how much they can risk.

For example, if a trader has a $10,000 trading account, after doing the 5% calculation, they will know they cannot take a trade(s) that puts more than 500 pips (a pip is worth about $1 in an FXCM standard account) of their account at risk.

So if they see the above trade on the USDCHF with a 225 pip stop, they will know they can trade one 10K lot at 225 pips of risk. They could also trade two 10K lots for a total of 450 pips of risk. But, they could NOT trade three lots since that would represent 675 pips of risk and that would exceed the 5% rule and, by that standard, the account would be overleveraged.

The key here is that we know we are going to have losing trades. That is simply a fact of trading life. So we want to position ourselves so that when those losing trades take place, the loss that we incur will be small and manageable and a 5% loss falls into that category.

By limiting our losses in this fashion, we will be able to “stick around to trade another day”.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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