Can You Trade More Profitably Without Stop Losses? The truth about forex trading is that even when forex hedging strategy protection against losses and gains trader accurately predicts market direction they often fail to profit from that knowledge.
The thing that stops them from doing that is usually their stop loss. If you’re using stop losses in your trading strategy and they’re working for you then all well and good. However if you think there’s room for improvement, and there nearly always is, its well-worth spending a bit of time looking at some of the alternatives to stop losses. Trading without stop losses might sound like the riskiest thing there is. A bit like going mountaineering without safety gear. Yet with the right risk-control in place it’s not as crazy as it first sounds. Moreover, as I explain below your stop losses may not actually be providing you with the protection that you think they are.
Stop Losses and the Law of Diminishing Returns The natural reaction when traders try to reduce the numbers of stopped-out trades is to widen their stop losses. But there is a law of diminishing returns in doing this. Figure-1 shows how wide the stop loss needs to be versus the probability of the stop being reached. This example is for EURUSD over a 12 hour time frame but that’s not important. What’s important is the shape of the curve. This means you need a correspondingly bigger and bigger stop loss to reduce the chances of it being reached.
12 hours you would need a 45-pip stop distance. The further along the curve you go, the bigger the jump needed to get to lower stop-out percentages. To see how these curves are calculated see here. Reasons for not using stop losses in forex Not all traders use stop losses, for one because there are often better ways of managing risk, such as with hedging as we’ll see below. But first, here are some of the arguments against using stop losses. If your broker is a dealer they’re also making a market for you.
Unlike an ordinary broker a broker-dealer can take market risk. That means they may not be entirely impartial. They could potentially be on the other side of your trade or those of many other clients. This means your loss is their profit. When the dealer can see at what price orders are set to exit, that gives them an unfair advantage. They just don’t have the muscle to swing the market to eat-up stop losses in pacman-like fashion.
Given the kinds of legal actions we’ve seen regulators take against some brokers, this doesn’t seem too far-fetched. When the price is the same, a widening spread can only ever trigger a stop-loss. Therefore if the spread is fluctuating it’s far more probable to have a trade stopped-out rather than reaching a take profit. This is why many forex trades on the retail side end in loss. How many times have you looked at a trade that’s been stopped out only to see the market happily moving in the direction you first predicted?
This happens classically when a volatility spike fires a stop loss, and so closes the position. Far from being smooth and orderly, forex pairs have a tendency for bursts of high volatility. These events are common at breakouts. These fake-outs are where the market makes a false break in the other direction before eventually reversing. Most trading strategies will hold more than one trading position.