When to Move a Stop Loss to Break Even

By: DailyForex.com

One of the most common and expensive mistakes made by traders is moving the stop loss on a trade to break even too quickly. It is psychologically attractive to move a stop loss to break even in order to enjoy the feeling of removing risk, but it is usually not a smart thing to do as it tends to result in being kicked out of potentially profitable trade too early. Stop losses should only be moved either after a defined period of time has elapsed, or after the trade has moved in the trader’s favor by a relatively large amount, compared to the risk of the trade. Other methods of judgement tend to produce poor results.

The question of whether you should move a stop, and if so, when you should move it, depends also upon your style of trading, i.e. your tolerance for losses and your profit targets.

Should You Move a Stop Loss to Break Even at All?

There is a good argument for never moving a stop loss to break even. After all, if you test the profitability of a good trading strategy with clearly defined rules, moving stops will rarely make a great deal of difference to the overall profitability. If you treat the question of when to move a stop as art rather than science, you need to be a very good trader to get good results with it. Most new traders are probably better off avoiding moving stops at all, except for example where a trade is, say, already three-quarters of the way to its profit target.

If you have entered a trade and it has moved in your favor, all is going well. Remember that when you move your stop loss to break even, you are potentially limiting the upside as well as limiting risk. In fact, moving a stop is, in a very real sense, statistically the same as taking a profit. Why take profit early if you have faith in your trade entry? All you are doing is inviting the regular and normal volatility of the market to remove you from your position, and if you don’t have a position, how are you going to make any money?

 

The Statistical Reality of Trade Entries

If you look at all your trade entries, or a lot of entries generated by a strategy, you will find that in most cases, the price comes back to the entry level, even after a relatively considerable period of time has elapsed. Even when a technical development has occurred that indicates that the price is not going to come back there, for example carving out a higher swing low or lower swing high, it is still likely to return and hit your newly breaking-even stop loss.

To give an example, I examined a trend trading strategy that has recently produced excellent results. The stop loss is one day’s average range, so it is adjusted for volatility. I looked at all the really good entries: the ones that produced winning reward to risk ratios of at least 5 to 1. The result was that it was only safe in about half of these cases to move the stop loss to break even once 48 hours had elapsed. Of course, this was a longer-term trading strategy. However it goes to show you that while it may be true that many of the very best trades go into profit right away, this is not usually statistically common enough to build a winning strategy upon.

 

Common Approaches to Adjusting Stop Losses

Defined Time Period

One approach that can work is to wait for a defined length of time, one that should have given your trade enough time realistically to “breathe”. Once this time has elapsed, if your trade is showing a loss, exit immediately; if a profit, move the stop loss to break even. If you apply this method consistently, you could save in early exits from bad trades what you miss in any early exits from trades that turn out to be good trades after all.

Floating Profit Equals Certain Amount

You could apply the maxim “don’t let a winner turn into a loser” by moving the stop to break even once it has performed well enough to be out of the “orbit” of the entry level. You will probably be best served by waiting for the trade to be in profit by at least 3 times the amount of the stop loss before doing this.

Trailing Stop Loss

This can work, but should also not be applied until the trade is in profit by at least 3 times the stop loss, and the size of the trail should be based upon volatility.

Technical Stop Loss Adjustment

A very common approach, which usually involves waiting for any of the following to occur:

  1. A failed retest of the entry point

  2. A significant higher high or lower low that “confirms” the entry

  3. A successful breakout in the direction of the trade

  4. A failed breakout against the direction of the trade

These can work sometimes, but will not usually work often enough, especially in intraday trading.

Fixed Pip Amount of Profit

Here the stop loss is moved to break even after some fixed amount of floating profit has been achieved. This is a bad idea except where the price is much closer to the take profit point than the entry point.

 

Conclusion

Moving a stop loss to break even is the same as taking profit. If it is too early to take profit, there is no point in moving a stop loss to break even. Except in cases of very skilled traders, it is hard to be profitable if you are aiming for an average reward to risk ratio less than 3 to 1, so it is probably a bad idea to be moving stop losses to break even any sooner than that.

Every currency pair or cross has an average daily range of volatility. If your stop loss level is within half of that amount, it will probably be hit within the next day or two. Consider whether that gives it enough time to reach the kind of profit target you are looking for.

Do not be in a hurry to adjust a stop loss.

Adam is a Forex trader who has worked within financial markets for over 12 years, including 6 years with Merrill Lynch. He is certified in Fund Management and Investment Management by the U.K. Chartered Institute for Securities & Investment. Learn more from Adam in his free lessons at FX Academy.