Risk Management 101

07 - Common Mistakes in Setting Stops


While stop losses can help a trader prevent larger losses on his trading account, common usage mistakes might lead to a worse performance. Here are some of the ones that must be avoided.

One of the most common mistakes beginners make in setting stop losses is placing them too tight. Of course the fear of losing is still very much present among beginner traders or those who are just transitioning from demo to live trading, and it's no surprise when some are guilty of putting their stop losses too close to their entry levels.

While this seems to minimize losses in case the trade doesn't go in your favor, you also expose your trade to the possibility of getting wiped out right away before price even gains traction and eventually heads the way you thought it would. Bear in mind that price action for some currency pairs, such as GBP/USD or GBP/JPY, are usually more volatile than others so there's a chance that price could spike around first before picking a clearer direction.

Some traders opt to use a combination of a volatility and chart stop in order to avoid setting stops that are too tight. This comes in handy when trading currency crosses, which tend to be more volatile compared to major pairs. You can take into account the pair's average daily range or average weekly range in ensuring that your chart stops are beyond those pip amounts.

On the flip side, setting stops that are too wide is also another common mistake. While this ensures that the stop loss isn't likely to get hit anytime soon, this can lead you to trade position sizes that are too small and not be able to make the most out of your trade. In addition, this could lead to a small reward-to-risk ratio and negatively influence your trade expectancy.

Another common mistake in setting stops is using the position size as basis for stop losses. In fact, it should be the other way around, as the position size should be based on the stop loss and percentage risk per trade.

When you use the position size as the basis for calculating your stop, you are not able to take price action into account. Using a combination of an equity stop and a chart stop can be better for risk management if these elements are used as inputs in calculating your position size. This means that the number of lots you trade will be adjusted based on how much you are willing to risk and at which point you think the trade will be invalidated.

Perhaps one of the more overlooked stop loss mistakes is setting them right exactly on inflection points. Bear in mind that price could still have a chance at making a turn and heading in your direction upon testing support or resistance levels so it might be good practice to set a stop that's a few pips beyond these levels.