By John, TradingSpotSilver.com
See Part 1 Here: The Importance of Stop Loss in Forex Trading
Being punished by the markets is an oft heard phrase in forex. In the context of stop loss, some traders might think that the stop loss and take profit are two end points in a trade. However, you are able to better manage your losses, if you trail your stops. While most trading platforms allow you to set up trailing stops automatically, I for one am not a big fan of it. Automated set ups, while take out the emotional factor still fail to consider some important aspects such as price action (unless you have a custom built trailing stop EA that considers all aspects to do the job for you).
Stop losses is an effective tool to lock in whatever pips the market gives you. While this can be a double edged sword, at the very least as long as you can break even on your trade, it is a winner.
Trailing stops, in our context is nothing but trailing the pips in order to lock in the profits. Using trailing stops is an art in itself and you simply cannot expect to continue locking in your profits as the trade moves closer to your take profit levels. On the contrary, given the unpredictability of the markets, trailing stops when used without prior research can in fact kill your potential of making more pips per trade (for some traders, making 20 pips or so per day or per trade is more than sufficient).
In my previous article, I concluded with some tools that can be used by traders to plot important support and resistance levels. These, as we know are areas where we expect price to act (reverse, range, retrace).
The concept of trailing stops cannot be better explained than with charts. Let’s take a look at the EURUSD chart with Fibonacci levels plotted and see how stop losses can be used effectively.
The above chart is a recent one hour EURUSD chart plotted with Fibonacci levels. Let’s assume that given the recent fundamentals and the strong bullish run of the Euro; we go long at 50% Fibonacci level (@ 1.35319) with a stop loss set just above the 61.8% level (@1.34984). By moving our stops as price climbs up from one level to another, our initial risk exposure of -335 Pips can be reduced by moving the stop loss level closer to our entry at 1.35229 (+9 Pips). Since the market moved in the intended direction, we shift our stops to that gives us a profit of +9 pips, thus leaving us better off than breaking even on the trade.
So long as price hasn’t moved significantly beyond 38.2%, we don’t move our break even stop until we see a strong price rally at this level. When price moves from the 38.2% level, we then shift our stop loss to the 38.2% level, which is 1.35741 (+425 Pips).
If you believed there was still some steam left in the EURUSD rally, then just by shifting our stops, we would have moved the stop level right to the 23.6% level or 1.36263, effectively pocketing 944 pips.
Notice that as price touched the 0% level, (1.37108) the EURUSD reversed. While the price dropped back, we effectively managed to make a total of 944 pips on this trade, by simply shifting our stops.
Now if you compare this with using a pre-defined take profit level, we would have limited our profit taking level and even worse, by not shifting the stops, had the trade reversed much earlier it would have resulted in a loss, rather than make any positive pips.
Trailing or shifting stops is a common strategy and one that can be found with indicators such as the Ichimoku or the Parabolic SAR. It is best used during market volatility or when you are trading economic news releases. Using stops is the best way to make confident trades where even if you go wrong, your stops are there to protect your profits.
To conclude this two part article, I’d like to summarize that stops, when used correctly can be a great tool to not just limit your risks but to lock in profits as well. While you cannot become adept in trailing your stops right from the word go, practice makes one perfect and no better way to do this than to discipline yourself to shift your stops to break even once price moves away from your entry and continue trailing the price so as to pocket as many pips as possible.
About the Author
John is a full time forex trader and contributes regularly to tradingspotsilver.com, a blog focused on trading systems, trade analysis and MT4 tutorials.
