Types of Stop Orders

Types Of Stop Orders

1. Percentage-Based Stop

This is the most common of all stops. The trader must first decide how much percentage of his total equity he is willing to risk on a single trade. As already mentioned in Part 2 of Money Management, if you risk a certain percentage, say 3% on a trade, you work out your stop loss in pips and your lot size according to the 'fixed cost' of risk. Do not place an arbitrary stop on your position. Always make sure that you analyze the charts for the next significant support or resistance levels to give an idea of where is safe to leave your stop, and once you have calculated your stop loss in pips, adjust your lot size accordingly so that the amount at risk does not exceed your pre-determined percentage risked.

2. Volatility-Based Stop

Although still taking into account not risking more than 3% on a trade, a volatility-based stop is used, instead of price action, to set risk parameters. This method of placing stops is based on adapting your stop to the current market conditions. When the Forex market is experiencing high volatility, whereby prices traverse a larger range, the trader must adapt to this high volatility, and give more allowance for the stop so as to avoid being stopped out by intra-day market noise. The opposite holds true for a less volatile Forex market, whereby you can compress your risk parameters accordingly.

Bollinger Bands

Bollinger Bands are a type of envelope that are plotted at standard deviation levels above and below a moving average. This results in a widening of bands during periods of higher volatility, and a contraction of bands during less volatile periods. Bollinger bands allow for an understanding of changes in supply and demand for the underlying security as a quick view. Often there is a cluster of stop orders outside of the current trading range to protect against a breakout of the current trading range.

One way to place a stop using Bollinger bands during a period of high volatility is to measure the bandwidth of the Bollinger bands around the time of entry, and project half of that bandwidth from your entry price. You can then place your stop at that projected point. Figure 1 shows a 60 min chart of GBP/USD, with a bandwidth measuring around 95 pips from one end of the band to the other. So the estimated stop is half of that amount projected from your entry point, as indicated by the green circle.

Figure 1

If the currency pair has low volatility at the point of entry, project the entire bandwidth of the Bollinger bands from your entry point to place your stop there. Figure 2 shows a 15 min chart of USD/JPY, with a bandwidth measuring around 15 pips (low volatility). The green circle indicates the point of stop as projected by the bandwidth from the point of entry (circled orange).

Figure 2

Parabolic SAR

Developed by Welles Wilder, the Parabolic SAR ("stop and reverse") sets trailing price stops for long or short positions, which are indicated by small dots on the currency chart. The "stop and reverse" indicates when the trader should close his position or open an opposing position when this switch takes place. These price stops are dynamic, meaning they move incrementally along with changes in currency price.

In an uptrend, a long position should be established with a trailing stop that will move up every bar/candle (whatever the time period you are monitoring) until activated by the price falling to the stop level. In a downtrend, a short position can be established with a trailing stop that will move down every bar/candle (whatever the time period you are monitoring) until activated by the price rising to the stop level. Refer to Figure 3.

Figure 3

3. Chart-Based Stop

This often relies on a break in a trendline, moving average, or another key measure of support or resistance like Swing Low or Swing High. For example, if you trade a breakout of a Double Top chart pattern, a chart-based stop would be placed slightly above the neckline of the Double Top, since previous support should most likely act as future resistance.

Another example of a chart-based stop is illustrated in Figure 4, whereby if you trade the bounce of an up trendline for a currency pair, a chart-based stop would be placed slightly below the trendline support, and be periodically adjusted as the trendline slopes higher.

Figure 4

4. Indicator-Based Stops

If you have entered your trades based on indicator signals, your stop could also be based on signals from the indicator that you are using.

For example, you may have a buy signal for a currency pair when the MACD crosses up above its zero signal line, so a MACD-based stop, in this case, would be activated by the MACD reversing its previous signal by crossing back below the zero signal line (Refer to Figure 5).

 Figure 5

The problem with using trend-following indicators (such as MACD) as stops is that they are lagging, meaning that the currency pair may have reversed its direction suddenly, and you will still have to wait for the lagging indicator, like MACD, to catch up before you can cut your losses.

Likewise, for any other indicators or oscillators that you may use for entering trades, you can also activate your stops based on the opposing signals. For example, if you have a buy signal for a currency pair when the Slow Stochastics crosses up above its oversold line, your stop could be activated when the oscillator moves back down into the oversold area.

 Trading Tips

• Some people also use time-based stops in their trading whereby they time how long they want to be in the market for, and if the time is up, they close their positions accordingly.
• My personal preference is to use a percentage-based stop as I find it the most suitable for my trading style. Find one that suits your own trading style.
• No matter what type of stops you use, always make sure that you do not risk more than the pre-determined percentage of your total equity on a single trade.