Most traders would probably agree with the proposition that the hardest thing to get right in Forex trading is the placement of stop losses and take profit levels. A great deal of trading education and material that is shared with learning traders focuses on finding the right places to enter trades. Let’s be clear that entry is very important, but good trade management – i.e. using the right stop losses and take profit levels and changing these levels appropriately as the trade progresses – is equally important. It is very possible to be right about entries consistently and to still lose money overall. Assuming that you have a good entry strategy, how can you best exploit it? Is there a better, more dynamic methodology than just setting stop loss and take profit levels and walking away? There is, although this can be challenging as “set and forget” methods are psychologically easier to implement.
Dynamic Stop Loss
It is a good idea to never trade without a hard stop loss, i.e. one that is registered within your broker’s platform for execution, unless you are using extremely small position sizes. This is an essential part of controlling risk in Forex trading.
The stop loss may be made dynamic, as a way to lock in profits on a trade that progresses profitably. However, the stop losses should only ever be moved in the direction of reducing losses or locking in profit. In this way, a trade that performs well will end up giving some profit. This is also a good way to let a trade die a “natural” death, instead of aiming for profit targets that can be very hard to predict.
One example of a dynamic stop loss is the trailing stop. This may be set at a particular number of pips or based upon some measure of averaged volatility. The latter option is the better choice.
Another example would be moving the stop loss level periodically so it is just beyond major highs or lows or other technical indications. The beauty of this is that the trade stays alive as long as it is going well. When a long trade starts to break down through key support levels, then this type of stop is hit and ends the trade. This method is a way of letting winners run, while cutting losers short.
Dynamic Take Profit
First of all it is worth asking the question why it is worth using take profit orders at all in Forex. Many traders like to use them instead of moving up the stops and letting a trade end that way, for the simple reason that the latter method means you always give up some floating profit. But why cut a winner short? You might think the price is only going to level X but what if it steams ahead and keeps going? If you make a list of your last one hundred trades, I practically guarantee that you will see that using some kind of trail on the stop would have made you more profit overall than even your wisest application of take profit orders ever did. Of course, if your trading style is very short-term, take profit orders make more sense. Yet if you are trying to let winners run for days, weeks, or even months, then do take profit orders really do anything except pander to your fear and greed?
There is a possible compromise. You might want to use take dynamic take profit levels set at places relatively far ahead of the current price, which could be reached by a sudden news-driven spike, for example. This could get you some nice profit on the spike, and allow you to re-enter at a better price when the spike retreats. This is the most judicious use of hard take profit orders within non-scalping trading styles.
You might also use soft take profit levels, if you are able to watch the price make a very good, long “climax” candle. These can often be good points for quick exits and re-entries as described above. Be warned though, that this tactic requires real skill and experience to be applied successfully in Forex trading, and is a worthless trail for more novice traders to travel down.
Charles Darwin’s Theory of Evolution suggested that the fittest elements within a species were most likely to survive. We have all seen this when we grow plants in a garden. Usually, the baby plants that look the strongest and tallest are the ones that eventually grow into the best specimens. Expert gardeners pull up the sick and weakly plants and leave the strong ones to grow, and harvest those when they begin to die. Profitable Forex “Darwinist trading” can be achieved in exactly the same way, by using a combination of hard and dynamic soft stop losses / take profit orders to effect the pruning and harvesting by cutting losers short and letting winners run. A stop loss that results in a profit can be called a take profit order, when you think about it.
In Darwinist trading, the strongest trades survive, and the weakest performers are culled.
We can demonstrate how results can be improved by using easily quantifiable “Darwinist trading” techniques, using the past three years of the EUR/USD currency pair as a case study.*
Long trades were entered when a fast exponential moving average crossed a slow simple moving average on the hourly chart, provided all the higher time frames were also in alignment (up to and including the weekly time period). An initial hard stop loss equal to the 20 day Average True Range was used.
The naked back test results were very positive: out of a total of 573 trades, 53.40% of the trades hit a profit equal to the hard stop loss, and 25.65% of the trades hit a profit equal to five times the hard stop loss, before hitting the hard stop loss. These naked results show why it is so much more profitable to let winners run.
Now, let’s look at how many trades were showing a profit 2 hours after entry. Only 48.31% of the trades fit this category. However, if we look at all those trades which eventually hit five times the hard stop loss, we see that 57.44% of these trades were in profit 2 hours after entry. Five times the average true range is much further than the average volatility of two hours, so there is a momentum factor in play.
In fact, this can be shown even more simply by looking at the results of trades taken when the higher time frames were not showing the same momentum:
Note how the results generally worsen the fewer high time frames are exhibiting the same momentum alignment. Clearly, when a currency pair has been moving strongly in one direction for several weeks, it is more likely than not to keep going.