How Do you calculate stop loss size based on market conditions?
In this article, I will explain how.
The most simplest way to calculate stop loss is called the percentage stop loss method.
The percentage stop loss is based on calculating a percentage of you trading account you are willing to risk in a trade, for example 2%.
After that percentage risk is determined, the forex trader then uses position sizing to see how far away his stop loss can be placed from his entry price.
For example, if you have a $10,000 forex trading account and you are risking 2% in a trade than that is $200 you are risking.
Now, with a rough quick calculation, $200 is 20 pips on EURUSD currency pair on one standard contract trade. So your stop loss must be set at 20 pips for you to have a trading risk at 2%.
So lets say that you sold EURUSD and placed your stop loss at 20 pips from the entry price.
You have done the right thing, right?
Placing A Stop Loss At An Arbitrary Position Is Not A Good Idea
Yes, I know, you will come across forex trading strategies that say place your stop loss 10 pips, 20 pips, 20 pips, 30 pips or “x” pips away from your entry price.
But when you do that, you are not taking into account the what the market is telling you.
So what is the market telling you then? Well, the market gives you support and resistance levels, right?
These are essentially swing highs and swing lows of price basically.
Therefore best place for stop loss placement is behind resistance levels (swing highs) and support levels (swing lows).
Because of the fact the price as already established a level where it failed to go past therefore placing stop loss behind these price levels ensures that you have less chance of your stop loss being hit.
Does this make sense now?
Imagine someone placing a stop loss on a sell trade on GBPUSD with a 10 pips stop loss. And this stop loss was calculated on how much he is willing to loose instead of of placing a stop loss based on market conditions.
Here’s what his trade would look like:
But what he fails to understand is this: GBPUSD moves more than 100 pips a day.
So what does that mean?
It means that he could easily get stopped out with just a small move of GBPUSD currency pair.
His problem now is the fact that he has calculated his stop loss based on how much he wants to loose instead of what the actual market conditions of GBPUSD.
And when you do that, such situation tends to happen:
And so he gets stopped out from a trade because the stop loss was too tight. And guess what happens next? The market made a 100 pips move but he missed out on that.
Here is the right way to do this and here are the steps:
- first identify where you are going to place your stop loss and this must be based on the market conditions…look for swing highs and swing lows. For example, you want to sell GBPUSD and you note that to place your stop loss, you have to place it above and just outside of the resistance level (swing high).
- calculate how many pips away is that stop loss price level from your potential trade entry price level. For example, lets say it is 20 pips.
- The next thing you calculate is your trade position size based on that 20 pips stop loss to keep your trading risk at 2 % (as an example).
Summary On How To Calculate Stop Loss Size
You need to work our your stop loss distance in pips from the market first and then calculate your position size based on that and not the other way around.
So what is the other way around (the bad way?).
Its this: calculating your risk and how much money you are willing first and converting that into how many pips stop loss that equates to and then placing that stop loss at the market.
That is the wrong way to calculate stop loss.