Setting Stop Loss and Take Profit Targets

There is a dilemma that seems to confound many retail traders where we see them making this mistake time and time again.  This problem  is the issue of setting stop loss and profit targets for their trades. Many traders simply set these targets arbitrarily without any principles guiding their actions.

Picture this scenario: a trader decides to go long on the EUR/USD at 1.2950, with a profit target of 1.3000 and a stop loss of 1.2920. The nearest resistance is at 1.2910, and the EUR/USD retraces to this resistance before it takes off on a bullish move to 1.3010, where the nearest support is located. So even though the trade eventually went the way the trader expected, his stop loss was triggered and he lost the trade.

Has this ever happened to you?  Well, it has happened to a lot of people and even happened to me in the early days of my dumbness and naivety in the Forex markets years ago. That was until I discovered the secrets of setting stops and limit targets in the Forex market.

Currency prices can actually think.  They know when they are about to get to key levels of support and resistance, as well as the psychological support and resistance price levels, and whatever the trader does, they will respect these levels.  That is why any trader who does not take into account these key levels of support and resistance, or does not respect what the candlesticks are screaming out on the charts, will continue to experience issues with setting good stops and limit targets.

To illustrate this, we present this snapshot below:

This chart shows a hypothetical long trade on the EUR/AUD which was taken at the daily pivot. The big question is: where does the trader set the stop loss and profit limit targets for these trades?

First scenario: if the trader sets the price anywhere between the entry point and the first support level (S1) as shown by the autopivot calculator at 1.23346, that trade will end up a loser as prices firmly retreated to the support level before taking off on a bullish note to end higher.

Second scenario: if the trader respects key levels of support and resistance and sets the stop loss below S1, the trade would have had enough room to breathe and accommodate the draw-down from the daily pivot to S1.

Looking at the same snapshot, we can also see that the price started an advance after the initial draw-down, retreated back to the daily pivot and completed a strong move all the way up to R3.  R1 and R2 were broken by strong price action and fundamentals (the latest bailout of Greece by the IMF and the ECB).

Lessons to be learnt from this set-up are as follows:

a) Before taking a position in the market, be it long or short, always ask yourself if where you want to place the market order is close to a key price level or some distance from it. The fact is that you must set your stop loss beyond the nearest level of support (for long orders) or resistance (for short orders).

If where you want to trade from is a bit far from these key levels, would you be willing to accommodate a draw-down should that could occur?  Can your account handle it?  This is a pertinent question because there are others who have definitely been in the trade before you when the price was at either extreme of range, and who are ready to ride it out to the next key level.  So if where you are is not close to any of these key levels, be prepared to accommodate a draw-down.

c) If you cannot accommodate a draw-down, then use a pending order (usually a limit order) for the trade. In our example above, the order to have used would have been a Buy Limit at S1, using the daily pivot, R1 and R2 as 1st, 2nd and 3rd targets.

In conclusion, never set stops and limit targets without considering the support and resistance levels.

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