What Is A Stop Loss And Take Profit?

As a new trader, it's crucial to understand how to set a stop loss and take profit on your trades. This knowledge is the foundation for money management.

When you place an order with your broker, there are two things you need to know before entering the trade –

1. How much are you prepared to lose?
2. Where are you going to exit the trade for a profit?

Without these parameters, you are flying in the wind. So, in this chapter, we'll explain what a stop loss and take profit is. We'll demonstrate with visual examples, so you can get the idea of what to look for when deciding where to enter and exit a trade.

By the end of this chapter, you will know the importance of choosing where to place your stop loss and take profit and learn where NOT to put your stop loss and take profit.

What Is A Stop Loss?

After you have done your analysis, you decide on your level of risk. You have studied the charts and have picked out an area that, if price pulls back, the trade will close for a loss.

A stop loss prevents you from experiencing significant losses.

Imagine if you had an open trade for a short position on GPBJPY at an opening price of 1.4050. You are hoping the price will fall and you can follow the profits down. But GBPJPY disagrees with you. It decides to go up, and it goes up fast and hard. You think, you hope, it will come back down soon, so you leave the trade open, but your losses are mounting. Now, it seems too late to get out, and you pray beyond hope that the price comes around so you can breathe again.

The stress and anxiety of being in this position will destroy you as a trader.

Nobody likes losing, but it's a given in Forex. Success is NOT about avoiding losses. It's about capitalising on wins and minimising losses. Even professional Forex traders may have a relatively low win rate, BUT they make sure their wins are significant, and their losses are small. With an excellent risk to reward ratio, you can have a 50% success rate and still come out on top.

Placing a stop loss on ALL orders takes away a lot of unnecessary pressure. You will know 100% how much you are risking, both in monetary terms and as a percentage of your capital.

How Do I Know Where To Place A Stop Loss?

There must be some form of logic for where you place your stop loss. For instance, it won't work having a strategy whereby you routinely set a stop loss of, say, twenty pips. You have to look at the market structure to see where the price has been before. Then you assess the probability of whether you think the price may pull back against the direction of your trade.

It would be best if you allowed the trade room to breathe. Having a tight stop loss might seem a good idea. You reason that your losses will be small. You will, however, likely find yourself stopped out more times than not. Novice traders tend to do this because they focus on how much money they can make and how much money they DON'T want to lose. This approach is counterintuitive.

When deciding upon where to put your stop loss, always check the market structure. Most novices to intermediate Forex traders will place their stop loss above or below the last high or low. The problem with this is that it makes the trade vulnerable to stop loss hunters. As we have discussed before, the big boys know these are the zones where retail traders place their stop loss. They will dump some money in the market, create a big spike and take out the retail stop losses. And, typically, your trade gets taken out and then proceeds to move to the area where you would have taken your profit. This price action is called stop loss hunting.

Before you even think about how much you can win, a golden rule is to make sure you know what you could lose. If the potential loss is more significant than the win, walk away and wait. You can always find another trade, and a better one at that.

How Do I Overcome Stop Loss Hunters?

Be patient. If you are waiting for the price to hit a zone, let it touch and move away. You will see this on the charts all the time. The price bounces off support or resistance, then moves out and comes back. Sometimes it moves away again then spikes back. THEN it moves in the direction you want.

Below is a visual representation of stop loss hunting in the markets.

Let's analyse the above example of USDCHF on the 4-hour chart

1. Price touches support
2. Price moves away
3. Price spikes below the last low
4. Now, the price moves up, and it continued to do so.

So, the previous low was above the red line. A novice Forex trader would put the stop loss under #1 on the chart. And, as you can see, you would have been stopped out at #3 when the market spiked below the last low.

The likelihood from this point is that the price won't come back below the spike. It may go down again to retest support at #1 (It did). But if your stop loss is under the price spike, the probability is reasonable that your stop loss won't get triggered. If the price comes back to retest the support, this could represent an opportunity to open a trade. Of course, there are no guarantees.  Forex is only ever about probabilities. But you can select trades with the highest chance of success.

This scenario above is a PERFECT example of stop loss hunting. Check out the charts, and you will see this pattern repeated countless times.

Slippage

Forex slippage happens when your stop loss is triggered and closes your position at a price below or above your pre-determined stop loss. For instance, let's say your stop loss is at 1.2000 on EURUSD. There is a sudden news event, and volatility goes haywire. Your stop loss is triggered, but you notice the trade exited at 1.19840, not 1.20000.

That is slippage.

Slippage generally occurs when market volatility is high or on the news or economic announcements. It can also happen at times when a currency pair trades outside of peak market hours.

Always watch the market for a while before you place a trade. Is it looking static? Does it have a good flow? Or, is it spiking all over the place? If it's the latter, run for the hills. Or at least make a cup of coffee until it all settles down.

Look at the enormous candles in (any) chart history. We mean really huge candles! This sort of movement is a demonstration of high volatility. Market prices can change in a heartbeat. Slippage can even occur when you are placing a trade. You can take steps to avoid this scenario by checking the economic calendar for upcoming news. We cover this in chapter 4.

What Is A Take Profit?

A take profit area is a designated price at which you will exit the trade for a profit. You have studied the charts and decided upon an area of high probability for price action zones.

How Do You Decide Where To Take Profit?

Let's look at the USDCHF 4-hour chart again

Looking back, you can see three areas where price has reversed (Blue arrows) If you were taking a long trade from support, this would be a logical first target area to exit a trade. If you had two trades open, you could move your stop loss to break even. You could set a second target, keep the stop loss at break even, or use a trailing stop loss.

We've previously discussed setting the risk to reward ratio to a bare minimum of 1:2. If this isn't possible in this trade, you might want to leave it alone. The spike is quite deep, and the first target is not so good.

Key Points From This Chapter

1.   A stop loss is a way of protecting your account by minimising your losses.
2.   A take profit is a logical area for you to designate your trade exit point.
3.   Look for logical areas to set a stop loss – avoid the stop loss hunters.
4.   Check history on the charts to ascertain probability for your take profit areas.
5. Be patient – study the charts – don't be in a rush to get into a trade. Look for minimum 1:2 risk to reward AND set the smallest stop loss with the highest probability.
6.   Slippage is when price movement slips below or above you set stop loss.

Conclusion

You now know the reasoning for setting a stop loss and take profit. It makes sense to look for logical places to designate your entry, exits and risk. Practice on a demo account, spotting the best areas on a chart.

In the next chapter, you will learn about how to use an economic calendar

Next: Learn How to Use an Economic Calendar