The Bigger Your Stop Loss

There are many traders that are scared of trading with big stop losses.  They have tried to optimize their system to death to try to get the best possible entry price, and tweak their system and settings so they can get in with the smallest possible reasonable stop loss level.

Why do they want a small stop loss?  Well, if they employ a % risk model, then a smaller stop loss means a bigger position size.

For example if the market moves 500 pips.  There can be multiple traders trading that same move differently with varying stop losses and thus position sizes, and reward risk ratios.

Trader 1:  Captures 500 pips profit, using a 250 pip stop loss, and thus has a reward risk ratio of 2:1

Trader 2:  Captures 500 pips profit, using a 100 pip stop loss, and thus has a reward risk ratio of 5:1

Trader 3:  Captures 500 pips profit, using a 50 pip stop loss, and thus has a reward risk ratio of 10:1

If all the traders decided to risk 2% on the trade, then:

Trader 1:  Would make 4% return

Trader 2:  Would make 10% return

Trader 3:  Would make a 20% return

There are obviously varying degrees of profitability on such a trade.  The trader that was able to get the best entry, position size with a smaller stop loss, and still win the 500 pip trade amount, will experience the biggest return.  Of course the drawback to this, is that the trader that uses a 50 pip stop loss to capture a 500 pip move, will typically have more losing and break even trades than the trader using a 250 pip stop loss.  Why?  Because the bigger your stop loss, typically the bigger gyrations you can hold through, giving your trade more time to achieve your profit objective.

The trader using a 100 pip stop loss or greater is usually a swing trader or end of day trader that doesn’t want to be at their trading platform often and glued to their screen.  The trader using a 50 pip stop loss is probably a day trader that likes to try to place a position intraday with a good entry and attempt to ride it for a swing trade.

Nothing wrong with either approach.

You shouldn’t be afraid of either approach.

There is nothing wrong with trading with big stop losses in the range of 100-300 pips.  Just know that the bigger your stop loss, the lower your position size.  You can still make a lot of money, you just need a bigger move.

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Which brings us to the trading rule:

The bigger your stop loss on a trade, the bigger the volatility you should be expecting.  If you can do that, then no matter which market you trade, you should be able to attain great reward risk ratios on your trades.

Therefore, in the forex market if you are placing trades with 200 pip or 300 pip stop losses, then you should be expecting a big move to the tune of 500+ pips or 1,000+ pips worth of attainable profits.  Which means there needs to be order flow triggers and scenarios that will move the market that much.

Which brings me to the next point.  If you are placing ten trades during the month on the same currency pair, all using 300 pip stop losses, I would say you are doing something wrong.  The reason is that the market doesn’t make 1,000 pip moves ten times a month.  That is almost impossible.  Therefore you expectations are out of line with what the market volatility can be.  In such a situation, better order flow research and timing the market is critical so you can better place trades that have reasonable stop losses in tune with the market volatility.

Back in 1992 when George Soros broke the Bank of England, he had a flexible mental stop loss of around 300-400 pips in place.  He had good reason to use such a big stop loss.  For he was expecting a big move to happen.  When the market moved over 1,000 pips in his favor, the big stop loss strategy was vindicated.  He was successful because he had a order flow and global macro reason for a big move to occur.  He wasn’t relying on moving averages, stochastics , chart patterns, etc.

Don’t fall into the trap of using big stop losses with tiny profit targets.  All sorts of traders attempting to use 200 pip stop losses with 20 pip profit targets.  There are even some forex robots that still do this!  They have high win rates for a short while and they think it is the holy grail.  Lots of small winners rack up and it helps to instill a false sense of confidence in the trader.  Then when the inevitable loss comes, it completely wipes out all your small profits and causes a loss.

You may ask, well what if I want to trade with a big stop loss but cannot find a big move to occur?  Then you either need to find a way to fine tune your entry on a smaller time frame, or find another market that will make a big move, or skip the trade and wait for a better reason for the market to make a big move.  You can read my previous article on what to do in choppy markets.

Trading Money Management Reminders

The bigger your stop loss the bigger the move you should be expecting.

There is nothing wrong with using 100 pip stops losses or 200 pip stop losses, so long as if you positioned sized like that, you are expecting a big move to happen.

You can position size for a 200 pip stop loss if you expect a 1,000 pip move to occur.  Because that way your Reward Risk Ratio is still a very high 5:1.  Now if you can time a better entry on an intraday basis with a 100 pip stop loss or 50 pip stop loss, that would be better.

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