Figuring out where to set your stop-losses

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Though it may seem like one of the more mundane topics in forex trading, where you set your stops is a crucial factor in balancing risk and reward in your trades, while it may be tempting to set your stops close to your entry price, to tightly limit your potential losses, you inevitably leave yourself open to the market's whipsaws and retracements by doing so, and can end up racking up a lot more losses than you would otherwise.

Substantial distance is an important factor

Placing your stops a substantial distance above or below the current price leaves more room for back-and-forth ranging but can leave you with painful bite out of your account when the market decides to swing in the wrong direction in a big way.

It's also worth considering that some people don't trade with any stops at all (though I'm not one of them, and I'm not recommending you do it). As one trader's forum signature light-heartedly put it, "Look ma, no stops!"

How can anyone have the guts just to let their trades swing freely in the sometimes-violent winds of the market, with no "ejection seat" to bail them out when things get ugly? Well, suppose you've watched the need for a long time and have done your homework by examining and analyzing historical price data.

In that case, you'll begin to see how someone might become more comfortable with the idea. As I've said before and will undoubtedly say again, the data is your friend. For instance, when I did the initial backtesting of my trading system with historical EUR/USD data, I had absolutely no stop-losses built into the calculations. Hundreds and hundreds of theoretical trades were performed without a safety net, and the result was still very profitable. In fact, trading without stops proved to be more beneficial than trading with them in most cases.

However, there are occasions when a stop-loss will prove essential in bailing you out of a dangerous market. For instance, after a catastrophic event, the market may swing equally catastrophically in ways you'll want no part of. This is when you'll be glad to have your stops in place.

For the record, I'm currently running pretty sizable stops on all my long and short EUR/USD trades. To figure out where to set them, I used the same back testing system I used to design my daily trading entries and exits and ran the data with stops set at various levels.

For long trades, I found a stop-less set 118 pips below the entry price worked best. For short trades, a stop set 128 points above the entry price was optimal. In both cases, the stops added around 10% to my trading profits. (Keep in mind these stops worked best in the limited data set I was using - a different data set will probably produce somewhat different results.)

Conclusion

Finally, the timeframes you're trading in will be a key factor in where you place your stops. For example, my stops were designed using daily EUR/USD price data for trades that last a minimum of 24 hours. So, if you're planning to exit your trades within a shorter or longer timeframe, you'll need to use a different set of test data and adjust your calculations accordingly.