In my experience, and as I have discussed in other articles, I tend to focus more on what can go wrong rather than what can go right when it comes to taking a trade. Because of this, I always start with risk as my primary assessment tool. If I am unwilling to risk a certain specified amount on a trade, I won’t take it. It’s black and white.
My selection of a stop loss amount is usually a combination of factors, and dynamic based on key support and resistance areas. First, I look at the potential profit on a trade to determine if there is any way a feasible risk/reward ratio can even be achieved. I typically look for a 1:3 risk/reward ratio on all of my trades, but will drop lower (but no less than 1:2) or move higher based on different variables.
Once I determine my profit target, I calculate my default stop loss based on my risk/reward ratio. For instance, if my profit target on a trade is 150 pips, my default stop loss, based on math alone, would be -50 for 1:3.
I then look to the area below my entry level for a long position, or the area above my entry level for a short position, and mark up any key support or resistance areas less than -50 pips from my entry level. I determine whether or not, if broken, price is likely to go in the direction of my trade or against. If I believe the levels are strong enough, I am likely to tighten my stop loss just above these levels for a short position or below these levels for a long position (but not too close so they can be taken out by small spikes).
Its important to note that with most, if not all, of my entry points, I intend on very little drawdown. The entry techniques for this strategy calls for price to turn ‘on the dime’, and violation of areas of entry immediately imply that a trade is not working out as planned. The areas marked up in between my entry level and default stop loss based on risk/reward are more or less ‘meters’ for me to ask “if price exceeds my entry level, where is it likely to turn next, and if it exceeds that level, am I calling it quits?”
Many times, clues on smaller timeframes can tell you that a trade will not work out as planned, and whether or not price is likely to continue moving against you. These opportunities allow you to close a position prior to your default stop loss getting hit, thereby incurring a smaller loss. Additionally, they allow you to reverse a position and trade in the direction of the prevailing trend.
In the example below, a long EUR/USD position was taken at 1.3080, with a profit target of +151 pips and a default stop loss at -50 pips based on 1:3 risk/reward. Price moved in favor of the trade for +59 pips before coming back and taking out 1.3080, the original entry point. Price then began using 1.3080 as resistance, waving a red flag that it is likely to continue moving lower, and against your intended trade. In a situation such as this, after seeing price use 1.3080 as resistance, there is little reason to leave the trade running against you and waiting for your default stop loss to get hit for -50 pips, when you could be out of the trade for only -10 to -20, and profiting from a newly created short position.
Many traders don’t pay close enough attention to these clues and it only hurts them in terms of overall performance. Focus, and more importantly, reaction to these clues is essential.
It’s not uncommon for a trader to get “married” to a position, and maintain their directional bias, when clues on smaller timeframes blatantly tell them that price is doing otherwise. Quick response by trading what you see and disregard of your prior bias is the only way out of it.