The most common type of stop loss is the percentage stop loss and this is calculated based on a portion of a a trader account.
For example, if you have a $10,000 forex trading account and you say you wan’t to risk 2% of your account in each trade you place, how much are your risking then?
Well 2% of $10,000 =$200.
The next question you need to answer is: how many pips is $200?
Let say you want to trade 100,000 units of EURJPY and each pip, in this case would be approximately $10/pip which means the largest stop loss you can place is 20 pips ($200 divided by $10/pip).
2 Main Problem With Placing A Stop Loss Based On Percentage of Your Trading Account
Here’s the number 1 problem:
Its better to show you based on charts examples so you understand.
For example, you place sell trade on EURJPY and place your 20 pips stop loss as shown on the chart below:
And the next chart below shows what happens after you place the trade:
Notice that this is a 4 hour chart of EURJPY and this currency pairs moves an average of 50-80 pips in a 4hr timeframe?
So in this case, knowing this behavior the stop loss should have been placed at least 80 pips from the entry price instead of 125.201 as shown on the chart above.
Now, if you trade 1 standard lot with an 80 pips stop loss as your risk, that $800 you are risking, which is 8% of your trading account you are risking and here’s the dilema:
- you don’t want to risk 8% of your trading account
- which means you don’t want to trade with a tight stop losstherefore you still need to place an 80 pips stop loss
- which means you cannot trade with 1 standard lot, but with something smaller…What contract size can if trade and if stop loss is hit can give you a 2% loss?
Answer: 0.25 lots.
- Therefore, you have to trade with a 0.25 lots with an 80 pips stop loss. This keeps your trading risk at 2%.
($800 x 0.25 lots= $200 risk which is 2% of your trading account)
So if you didn’t get what the number 1 problem of trading with a percentage stop loss then it is this:
- you will be placing your stop loss order based on how much percentage you want to loose instead of basing your stop loss on market conditions of the currency pair.
- this means your stop loss order is just placed at an arbitrary price level and not based on market conditions.
So when you do that, you will place your stop loss too close to the entry price level or at a price level that does not take into account technical analysis, price volatility etc.
So instead of getting 180 pips profit, you miss out when your stop loss was hit and price moved in the direction you anticipated after you are stopped out!
#2 Problem of Percentage Stop Loss
Here’s the problem: You are always going to calculate the percentage stop loss based on your trading account size that may be increasing or decreasing.
Therefore, if you have losing trades, this decreases your trading account size therefore you percentage risk you calculate will be based on that decreasing trading account size and do you know what this issue is here?
How Much Should I Risk Per Trade? (Risk Management For Beginners)
It will take a lot longer for you to recover from losing trades that someone who trades with a fixed amount stop loss regardless of what size his trading account is.
If this does not make sense, lets look at this example of two trader, lets call them Trader Joe and Trader Blow.
Trader Joe has a $10,000 and uses the 2% percentage stop loss method and calculates his 2% risk per trade based on that.
Trader Blow also has a $10,000 trading account and uses the fixed amount stop loss method.
Trader Blow risks $200 per trade regardless of what his trading account size.
Lets assume that:
- they both take 5 trades
- they both have risk:reward of 1:3
- they both have a $10,000 forex trading account
Trade Joe Trade Blow
Trade1 Win $600 ($10,600) $600 ($10,600)
Trade 2 Loose $212 ($10,388) $200 ($10,400)
Trade 3 Loose $207 (10,181) $200 ($10, 200)
Trade 4 Loose $203 ($9,978) $200 ($10,000)
Trade 5 Win $598 ($10,577) $600 ($10,600)
As you can see, for trader Joe:
- whether he wins or loose, he is still calculating his trading risk based on the percentage of whatever his trading account balance is.
For trader Blow, he risk only $200 each trade all the time whether his trading account balance falls or not.
Tell me, who will recover quickly from a string of loses?
Trader Joe or Trade Blow?
Trader Blow is the one that will recover very quickly compared to the trader Joe and therein lies the number 2 problem of trading with percentage stop loss.
“Letting your emotions override your plan or system is the biggest cause of failure.” J.Welles Wilder Jr
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