Types of Stop Loss
Also referred to as a protective stop, a stop loss is effectively a market order which automatically closes a trade once prices cross a predefined threshold. Its main purpose is to limit your downside and is usually placed at the time of trade entry.
The three basic approaches to using a stop loss include:
- Manually adjusting the stop loss
- Automating the stop
- Semi-automating the stop
Which method one chooses depends upon their trading style, timeframe and strategy. But a trader should also decide whether they want to use a hard or soft stop loss.
If a trader places a stop-loss order via the MT4 deal ticket, then they are using what’s known as a hard stop. The advantage of a hard stop is that it is a mechanical way of exiting a trade if the market turns against you. It is often said that traders are more before the trade than after they have opened enter one. Therefore, deciding on an exit level and placing a hard stop at this level can be a good way to remain rational after the trade has been placed.
Another advantage of using hard stops is that it allows a trader to use a trailing stop and lock in profits if the market moves in their favour. Furthermore, the stop loss order will be activated when they are away from their computer and even when their computer is turned off. This because stop loss orders are stored on the trading server which run 24 hours a day.
The downside to a hard stop is that spikes of volatility can close out a trade prematurely, only to see the market continue in its original direction without you. And if volatility is high and liquidity is low, price action can gap past a hard stop level, resulting in a larger loss larger than originally intended.
Soft Stops / Mental Stops:
Instead of using a stop loss order or algorithm to close a trade automatically, some traders prefer to use a “soft stop” (also referred to as a mental stop). A soft stop simply means that the trader will manually close a trade once a pre-defined price has been crossed, so no automated stop has been placed within MT4.
It is debatable as to whether a trader should use this approach, particularly if starting out. But it is an approach many use such. For example, scalpers aim to take just a few pips out of the markets and many do not use a stop, as they intend to exit the market almost immediately if prices go against them. But there are also longer-term investors who do not use a stop loss order.
To use soft stops effectively, the trader should be disciplined enough to close out the order once price action has traded beyond their soft stop level. Setting a price alert will then notify them when their level has been breached so they do not need to watch that chart all day. It is then down to the trader to manually close out the trade, or at least review their open position to make sure it wasn’t a momentary price spike which triggered their alert before considering whether to remain in the trade or not.
MT4 offers three ways to receive alerts, and they can be setup within MT4’s option window (Ctrl O):
- Notifications (iPhone or Android)
- Email notifications
- FTP notifications
Combining hard and soft stops
Another approach is to use a combination of a hard and soft stop to manage your initial entry and management of a trade. In doing so the trader enters the trade with a rational exit plan (hard stop) and they can revert to a soft stop to manage their potential profits with discretion as the market moves in their favour.
Another approach is to move the hard stop to break even once the trade has moved in their favour by a certain threshold, then revert to a soft stop approach.
In this example, a sell-stop entry was placed on AUD/USD (hard stop). At this stage the trader is not using their discretion, as they will be automatically stopped out if prices reverse quickly against them.
After trade entry, bearish momentum favoured the trader and prices fell by a reasonable amount. Yet when the trader next checked the chart prices had retraced near their entry level. Whilst they could have closed at breakeven, they decided to stay short as their hard stop had not been breached. After which the bearish trend continued to develop, and the trader reverted to using a ‘soft stop’ approach and set price alerts to warn of retracements, then use their discretion to trail the soft stop lower once swing highs had been created.
Using Price Action to Trail a Stop Loss
Trail behind a cycle high/low
In this example a trader has identified strong bullish momentum on the daily chart, and they use their bullish swing trading strategy on the hourly chart. The stop loss strategy is to trail the stop higher once a suspected swing low is in place. It would be up to the trader as to how they identify a swing low. Here, the stop was trailed higher four times before a large bearish candle stopped the trader out around 12,195 with a profit.
Trail behind a Prior Bar/s
Whilst swings are a decent way of managing risk for trend traders, a different approach could be considered for momentum traders.
Using the same example we note how a trader could trail their stop more aggressively to capture bursts of momentum, and remain flat (not in a trade) when prices retraced.
This stop loss strategy is quite simple and can be an effective way to manage a strong breakout or momentum trade.
To trail the stop higher we want to see:
- Two consecutive bullish bars
- The recent bar must have a higher low than the previous bullish bar
- The stop is then trailed beneath the low of the initial bullish bar (2-bar low)
On this occasion it initially performed very well and captured a decent amount of the move before the trader was stopped out around 12,130. On the second trade bullish momentum was less aggressive, yet the trader still managed to exit for a small profit.
The trader could experiment with how many consecutive bullish bars they use to trail their stop.
- More bars allow for greater breathing room for the trade, yet risks giving back unnecessary profits around a price reversal.
- Fewer bars are more suitable to strong momentum moves as they can lock in profits early. Yet can also stop a trader out prematurely and erode potential profits.
- A reasonable compromise is to switch to a 1-bar trail if a strong bullish candle occurs and use a 2-bar trailing stop for bars that are not elongated.
Using Indicators to Trail a Stop Loss
Indicators provide a visual aid to help with stop placement. The advantage of using indicators is that it removes some of the guesswork which can be associated with discretionary trading. They can also be used as part of an automated trading system.
Three basic approaches for stop loss indicators include:
- Fixed pip / point stop
- Percentage stop
- Volatility-based stop
Typically, such indicators will plot a line to represent a potential stop position, with bullish stops loss orders below current price and bearish stop loss orders above price. Of the three listed, our preferred method is using a volatility based stop as they allows for the ever-evolving dynamics of markets.
ATR (Average True Range) Stop Loss
An ATR stop calculates the average daily volatility over a given period of time. The user will then define how many ATR’s they want the stop to be away from price action. For example, if the ATR for EUR/USD was 50 pips a day and they wanted their stop loss to be 2x ATR, then the indicator would be 100 pips above or below price action on the chart.
In this example, a custom indicator was sourced from the internet for free. Whilst custom indicators will have different features, the two important ones are as follows.
- ATRPeriod (3): A 3-bar ATR is used
- Factor (3.0): ATR x3 is placed above and below price
Things to consider with ATR stops:
- ATR stops perform very well in strong trending markets and can keep a trader in a trend for much of the trend.
- They perform very poorly in non-trending markets. Therefore basic trend analysis remains vital.
- The indicator will switch direction/ colour when the line is breached by price action. However, this does not necessarily make it a good indicator to identify a change in trend.
- The trader could place their hard (or soft) stop on or beyond the ATR line.
- The trading strategy should define how close the ATR line is to price action; a strong momentum trader could use a very tight ATR stop, whilst a trend trader would probably want a much wider ATR stop.
Using Automation to Trail A Stop Loss
MT4 allows traders to automatically trail their stop. Being automated, it removes any emotion or decision making on your part whilst the trade is open and can be a good way to lock in some profits as market moves in your favour.
MM4 Trailing Stop:
MT4 provides the ability to automate a fixed trailing stop.
Place a trade > right click over the entry level on the chart > Trailing top > Select distance
In this example the stop is 40 points below current price. If prices retrace lower the stop loss will not move, but if prices are 41 pips above the stop, it will be trailed higher by +1 point.
* Please note that the MT4 terminal must remain open for the trailing stop to operate. *
However, for trailing stops to work without an instance of MT4 running a trader needs to use a VPS service (Virtual Private Server). These allows EA’s (expert advisors) and the inbuilt trailing stop to work on a virtual server and allow the trader to turn off their computer. Moreover, you can also receive notifications once a stop has been trailed. Whilst VPS is outside the scope of this article, there are many paid services available and most allow a free trial.