Let’s talk about Stop Loss Orders and risk versus reward. This is a very common issue and I always hear our students when they’re talking about trading about having stopped to tight and getting stopped out. Then there‘s also the issue of traders too easily being tempted and taking profits too early.

So how can we can avoid this and more importantly what can you do yourself to work the right time to exit the trade. So let’s, for example, say your trade is moving in an uptrend and the market is making higher highs, higher lows. It’s above the moving average, we’re also above the storyteller and everything’s going good.

Then all of a sudden we get a retracement. What do I mean by a retracement? Well, this is when the market hits a little high and then it falls back to around the level (lowest arrow) in the picture below and we get to a low.

So the chart I’m using to illustrate today is a Euro/Dollar (EUR/USD) and it’s on a 15 minute chart. It doesn’t really matter the date or time because we’re not bothered with that today because what we’re solely looking at is an actual trade and also a risk to reward analysis on that trade. So let’s just say you’re using the most basic system that maybe we have at Trading College, which is a kind of traffic light PTS system.

This is a market making higher highs and higher lows, so in a nice uptrend, and then we get a break for a retracement down. Our traffic light PTS system is super simple; as soon as you see a color change going from yellow then red, red, red, red, red, at the first green candle you’re supposed to take the long trade.

The long trade is quite simply the buy trade. So at the end of this candle, we’ve made a buy trade. Now, obviously you can see that this trade works out because I’m giving you an example about Stop Losses but ask yourself, at where would you decide to put your Stop Loss if you were taking this trade? Would you put it at the bottom of the initial green candle you bought from? Would you put it under the moving average (the green line nearest the arrow)? Would you put it under the 200 moving average (the next green line down) or place it somewhere in the black zone below both of them?

Now this is not a simple decision. There are a few schools of thought in deciding where to play your Stop Loss. I often prefer to use previous wave lows as Stop Losses because it basically makes my risk to reward quite nice. So what do I mean by that? So if my entry is on that green candle then, as you can see below, this is where I’d place my Stop Loss.

You can see that’s a 16 point Stop Loss or 0.14% on the way down. I’m trying to aim for at least two times that on the way up. So we’d be looking to get to 32.
So we entered it at the green candle high (bottom arrow), our Stop Loss is at the wave low (circled) and our 2-to-1 target is 32 (top arrow) . So this is luckily a successful trade. Now you often get people asking “why didn’t you get the total move?” “Why didn’t you go all the way to the top there?” The answer is that you never can; it’s very rare that you’ll buy in at the very bottom and sell at the very top. If you think you can do that every time you trade, you’re dreaming. The above is good example of what a successful trade would look like.

Okay. That was on a 15 minute timeframe. Let’s have a look at something on an hourly timeframe.

So we’ve got a nice downturn here, very useful for my next explanation. So the market moves below the moving averages (top arrow) and it breaks into a downturn; already making lower highs, lower lows. We’ve also got this lovely momentum trigger (bottom arrow) so it’s a nice short trade (i.e. sell). So going with the principles, if we’re using the traffic light system, anytime we break it into a color and we get the next red then we take a short (sell) trade.

I’m going to show you a few examples because there’s a lot of examples on this particular chart. Le me draw them all out for you here.

I’ll be very, very transparent with you. Not all of them work. But that’s life when you’re trading, not every single trade is going to be a winner but in this you definitely get a lot of them. There’s 6 opportunities here and the only losing one is arrow five.

Let’s look at my favorite one in this chart, arrow 4; that’s the one that looks like the most obvious sell position. Now, again, if you’re selling at arrow 4, where are you going to put your Stop Loss? Are you going to use the wave high? Are you going to use the moving averages? What are you going to d? That’s the question you’ve got to ask yourself when you’re taking a trade.

Here’s another way of thinking about it. Every time the market makes a new wave, it makes a retracement. What goes down, must come up and vice versa. Effectively what you could do is measure the length of the retracements. So here you’ve got 60 points, the next one is 33 points, the next one 44 points and finally 46 points.

So you can see there, there’s a few decent retracements there. The average of that was about 30 points so that would be the average. So if we measure from the low of the arrow 4 candle and go 30 points up that takes us roughly above the white line and this is where you’d put your Stop Loss.

Now, where is your target? Remember I said that we would aim for at least 2-to-1 risk to reward. If that’s 30 points where we measured it to then we’re looking for 60 points on the downside and that’s around here and let’s put the candidate or achieves that right here, take the ruler out. And this is how the trade would look once it’s completed.

So entry on the traffic light system (arrow 2), Stop Loss above the previous wave high and the moving average (arrow 1) and then a target of 2-to-1 on the downside (arrow 3).

This example is a really nice and free flowing trend. It’s under the moving average and it’s below the zero line on our Storyteller as well. Plus there’s a lot of things that are looking bearish here to help you with this trade on the way down.

Okay. So that’s just a couple of quick examples but you should now have a pretty good feel for how to use your Stop Loss and how to manage your risk to reward on a trade. Remember, if you’re interested in any of our courses, please through for a bit more information on our website.

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