Forex Stop Losses: Big v's Small

In the world of Forex, good advice is usually delivered out of context.

One of the worse cases is: "Your stop level must always be one half of your trade size".

But what does this Really Mean?

While this sounds like great advice, the realities of trading are very different.

For example, if you are targeting 40 pips, your stop should be no more than 20 pips.

On the surface it seems like a logical idea, but when you dig deeper, you'll discover the idea is fatally flawed. The main problem is that all currencies fluctuate within the bigger trend.

Take a look at the following example.

Using the logic above, we take 10 trades on the GBP/USD. Targeting 40 pips, our stop should be placed 20 pips away from entry. It is now assumed that we are risking 50%.

On our sample of 10 trades, we were stopped out 7 times and we won 3. The reason for these poor results is the GBP/USD fluctuates constantly. Even if the pair is not trending it will rise and fall 40 pips or more.

let's do the math:

7 Losers: 7 x 20 = 140 pips of losses
3 Winners: 3 x 40 = 120 pips of Wins
Total = -20 pip loss.

A better option.

If we increased our stop level to 40, and target 40, that would be considered wrong. We are risking 40 to try to gain 40.

However...

When we test the 40 pip stop on the same 10 trades, we are only stopped out 4 times. Because the trades were given more room to fluctuate, the stop was not hit so many times.

Let's do the math:

4 Losers: 4 x 40 = 160 pips of losses
6 Winners: 6 x 40 = 240 pips of Wins
Total = +80 pip Gain.

When deciding our stop levels, we cannot ignore the market and how it moves.

So is this advice wrong?

If it is taken out of context, yes.

To use this advice correctly, you need to work forwards not backwards.

If you decide that 40 pips is a safe stop level, for the pair you are trading. Try to take trades that target 2 times that level. If you do not think the market has 80 pips of movement, you may decide to pass on that trade.

I personally still take trades that target the same level as the stop. This is because I have faith in my trading system, and know that even in an extremely bad month, I’ll win 6 out of 10 trades. I would still be profitable.

Mark Rayner is the head trader at Forex Signal Live (http://www.forexsignallive.com/) - Join him as he delivers trading signals and good advice.

Understanding Forex Risk

In this article I want to deal with the mechanics of how to calculate your risk. I have a free indicator that will allow you to calculate risk dynamically before each trade is placed. Please download it and install it in your MT4 indicators folder, and load it on any chart.

Any system can take a string of losses. I have a video on trading cycles that illustrates the point. The idea of risk management is to be able to take a string of losses, and and survive.

Consider this equation:
Account size (times) Risk Percent (divided by) Stop Level.

So for example, if your account size is $10,000 and you want to risk 5% per trade and you have a 40 pip stop, the equation would look like this:

( $10,000 x 0.05 = $500 ) / 40 = 12.5

This means you would be trading a lot size of 125,000 k and 1 pip represents
$12.50

If you get stopped out at 40 pips your total loss would be $500

let me break this down further.

First we calculate 5% of our account using multiplication. 0.05 represents 5%. If you wanted to calculate 3% you would multiply your account size by 0.03. Once we have that total, we divide it by the stop size for each trade.

1. Account size is $10,000


2. We want to risk 3%


3. $10,000 x 0.03 = $300


4. So 3% of our account size is $300


5. To make sure we never lose more than $300 we divide it by our stop


6. In this case our stop will be 40 pips.


7. $300 / 40 pips = $7.5


8. So we should open a trade that represents $7.5 per pip

Dynamic Risk Levels

It is important to remember that each trade may have a different stop level. It is therefore not sufficient to calculate your risk level and apply this to every trade. For example, adopting the risk level above, you trade $7.5 per pip. If you were to change your stop to 60 pips and take a loss, it would equal $450 which means you actually risked around 4.5% on that trade not 3%.

The indicator you downloaded from forex signal live will allow you to quickly and easily change the stop levels for each trade, and it will dynamically update as your account size changes.

The Usual Warnings

No discussion about risk would be complete without the usual warnings.

I personally consider 5% too high: Let's assume we take 5 losses in a row on our $10,000 account. That is 5 x 500 = $2,500. You have just got started and your account size is now reduced by 25%! Ouch!

Of course I'm not accounting for winning trades, but assuming the worse case scenario. Now let's assume that you lost your sanity, and started trading at 10% risk. It only seems like a small 5% increase, but if you take 5 losses in a row you lose $5000. That is half your account.
Very Ouch!

At the 3% level, I could ride 34 losses, before I lost my account. I think I could do better than that with a coin toss. At the 10% level you would be out of business in 10 trades.

It is easy to think that this is not realistic, because you will have winning trades as well. It's easy to focus on the potential gain that 10% risk will give you. Even the best of traders have taken strings of losses. There are old traders, and there are bold traders, but there are no old bold traders.

So take my advice and start small, move your risk higher as you get more confident. I recommend that everyone starts at 1%.

- Mark

Mark Rayner is the head trader at Forex Signal Live (http://www.forexsignallive.com/) - Join him as he delivers trading signals and good advice.