As you must already know, a stop-loss order is an order a trader can set to close an open trading position at a specific price point or percentage to limit their losses. This is a very important risk management strategy in trading, and it comes to use when a trade is unsuccessful. You must master placing a stop-loss order if you want to protect your account because misusing it can cost you a large amount of money or lead you to miss profitable trading opportunities.
These are a few common mistakes traders make regarding stop loss order placement.
Setting Stop Loss Too Tight
Everybody knows that the financial markets are volatile, and the price is a very tricky thing. Although it may look like that you have figured out which direction it will take, the price may fluctuate just before moving that way. If you set a very tight stop loss order that is super close to the entry point, your trade is going to be affected by the sudden volatility in the forex market, and it can cancel your stop loss. As a result, you may end up missing a good opportunity of entering the market or get squeezed out of your position.
This is easier to understand with an example. Let’s assume that a trader was trading gold. They observed that the RSI left the overbought zone, and MACD formed a bearish divergence with the price. In this scenario, they opened a short position at $1,341 and set a very tight stop loss at $1,345 according to the last consolidation around this level. Now, at first, they thought the price would go down, and it happened too, making them happy. However, the bulls entered the picture all of a sudden and aimed to push the price higher. Although they did not succeed, yet the attack was unexpected, and it canceled the stop loss. As a result, they missed the opportunity to enter the market. This is why you must consider volatility while setting a stop loss.
Set Stop Loss Too Wide
Contrary to placing a too tight stop loss, traders also make the common mistake of placing too wide stop losses. If your stop loss orders are placed too far, the number of pips needed by your position to move in your favor is increased, which makes the trade risky. If you want to avoid making this mistake, you must always consider your risk-reward ratio. The potential reward for every dollar you risk is determined by the risk-reward ratio.
For instance, if your risk-reward ratio is 1:3, it means that you risk $1 to make $3. With a good risk to reward ratio, you can keep your take profits and stop losses connected to your position size. It increases your chances to earn more profits from the trade.
Setting Stop Loss Exactly at Support or Resistance
It can be dangerous to place stop loss orders exactly at the support or resistance levels because the price can return to these levels after the breakout. It can trigger your stop before moving in your direction.
Look at the EUR/USD chart below. There was an inevitable break of the support at 1.2214. On April 23, 2018, there was a negative piece of news for the EUR, and it resulted in a breakout. Right after this breakout, the trader placed the stop loss order at the support level. When the price moved back to the 1.2214 level, the stop loss order was broken. If the trader is not fast enough, he is going to miss the opportunity for entry. The sell order was also placed exactly at the support level in the chart below, which led to the price bouncing from it. So, you must be cautious not to set your order exactly at the support or resistance levels.
Not Determining Stop Loss Placement in Advance
It is very obvious that you must plan your strategy in advance in every step of trading, and stop loss order placement is no exception, yet traders forget about it sometimes. Before you decide to open a trade, you must know about your profit targets, exact entry point, and stop losses. By taking this strategic step, you can eliminate any emotion from clouding your decision because none of your capital has been at risk yet at this point. You can have a clear head and simply look at the chart to analyze the further direction of the price.
Moving Stop Loss to Break Even or Marginal Profits Sooner
Sometimes, the traders get too excited when they see that the price movements are in their favor, and they move their stop loss without analyzing the situation properly. It can lead to an unexpected loss. When the trader makes an entry, they must be able to recognize when their current analysis is wrong. The easiest way to determine this is by telling yourself that your reasons for the entry are disproven by the market if the price goes above or below your stop loss level. Keep in mind that no matter what, you must stick to your original trading plan if you want to overcome the emotional trading.
You can never move your stop-loss recklessly. It can only be done if the market proves that it needs to be done. For example, if the specific support is broken and the trading signals recognized by the indicators fall further, it may be a good idea to move your stop loss a bit lower. Similarly, if the key resistance is broken by bulls and other factors show an uptrend, you may move your stop higher.
Stop loss placement is essential for all traders. It is a crucial step to take in any trading strategy. However, as explained in the points above, stop loss order sometimes plays tricks on traders if they place it incorrectly. So, study about it better so you can avoid these mistakes and apply stop loss accurately to eliminate risks from trading.