So far in this series about the characteristics of a solid trading strategy, I’ve gone over picking a time frame, determining trend direction and deciding on your entry criteria. (I also did a post on using higher time frames and trend direction to filter your trades). It is now time to go over where to place your stop loss and take profit targets.
Initial Stop Loss Placement
Before we get started, here is something you should know…
Always use a stop loss.
I know there are some systems out there that do not have a stop loss. Or, some traders say they have a “mental stop” where if price reaches this level they will manually close the trade. Not having a stop loss usually means you are going to let a losing trade run too long in the hopes of a reversal. It only takes one bad trade like this to crush your account… so always trade with a stop loss.
Here is the basic rule of thumb as to where to place your stop loss…
Place your stop loss where the reason for entering the trade becomes invalid.
Basically what I’m saying is there is a point where you have to admit your entry is no longer a good entry. (I don’t want to use the word “mistake” because if you entered according to your trading rules it is not a mistake). Here are a couple of methods for determining where to place your stop loss…
A Set Number Of Pips From Entry
Depending on the time frame you are trading on, you can determine a set number of pips away from entry to place the stop loss. For example, if you are trading on the 1 Hour time frame, you might use a stop of 50 pips. Basically, you are saying if price goes 50 pips in the opposite direction from your entry, the entry is no longer valid and you should exit the trade and look for another entry.
Obviously, the number of pips you decide to use as your stop depends on the time frame you are trading and the currency you are trading. Higher time frames require larger stops. Plus, different currencies have different movement characteristics in the market. For example, you would probably need a larger stop loss on the GBPJPY pair compared to the EURUSD pair.
Previous Swing High or Swing Low Levels
The other popular method for determining stop loss placement is to use price action. Price action results in Swing High and Swing Low levels. Using the previous swing high or swing low in relation to your entry is a common place to put your stop.
The idea is if price goes beyond the previous swing high or swing low, your entry direction is no longer valid. Here is a photo to explain what I mean.
Initial Take Profit Placement
The first thing you must do is decide if you are going to have a take profit level or not. Unlike the stop loss, it is possible to trade without a take profit level. If you trade without a stop, there needs to be some rules as to when you close the trade and you need to be able to stick to the rules.
I personally like trading with take profit targets. There are benefits of using targets from a risk to reward standpoint because you can enter the trade with a plan. But there is also another reason I like targets you might not have thought about.
I read somewhere that the brain rewards accuracy by releasing a chemical that makes you happy. For example, if you are a caveman and want to hit a moving animal with a rock, there are a lot of calculations your brain needs to make quickly. You need to determine the distance, predict where the animal will be, take into consideration the weight of the rock, etc. So, if you throw the rock and hit your target… the brain rewards you.
If you don’t believe me, just take a balled up piece of paper and try to throw it into the trash. When you make it there is a slight jolt of happiness compared to when you miss. So, in terms of trading… it just feels good when your target is hit.
Here are a couple of methods for determining where to place your take profit targets…
A Set Number Of Pips From Entry
You could simply take the stop loss level and use a risk to reward ratio to set your take profit level. Using the same example as above, (50 pip stop loss on 1 Hour charts) you could use 50 pips (1:1 risk to reward), 75 pips (1:1.5 risk to reward) or 100 pips (1:2 risk to reward).
There are plenty of indicators out there which calculate Pivot Points in the market. These indicators give you multiple levels you could use as a take profit level.
Price Action (Support and Resistance)
Price action creates levels of support and resistance. These are important levels in the market where the market has reacted previously. For example, if price reaches a level and is rejected multiple times, this is a strong resistance level. If price drops to a level and bounces multiple times, this is a strong support level. These levels are good places to take profit since price has reversed previously at these levels.
The point of this post is to show that entering the market is not the only thing you need to take into consideration when placing a trade. You also need to determine where you are going to place your stop loss and take profit levels. In some cases, these levels might lead to NOT taking a trade.
For example, let’s say you get an entry signal and want to use price action to determine your stop loss and take profit levels. By placing your stop above the previous swing high you need a 200 pip stop loss. However, there is a strong support level only 50 pips away where you would normally place your take profit. You should avoid this trade since you are risking 200 pips to make only 50 pips.
Getting into the trade is one thing, but you also need to take into consideration what you are going to do (if anything), once the trade is live. You need to think about how to manage an open trade.
What ideas do you have for setting your stops and take profits? Share your ideas in the comments below.
Read the next article in the series: Trade Management.