Last updated on August 26th, 2019 at 06:25 am
What is a Stop Loss
Simply put, a stop loss is a pending order sent to the market that will get executed once a certain price point gets touched. There is no guarantee that the order will get executed at that price. Also, perhaps not commonly known, orders are not marked as a stop loss. What I mean here is that the order is marked as a ‘stop order’.
So what exactly is a stop order? It is an order based on a price away from where the market is currently trading. Although its most common use is to exit a position that is not working, it is also used to enter a position. This is why I mention that it is not marked in any way as an order that closes a losing position.
There is a common misconception among new traders that brokers know where their client’s stops are, and trigger them on purpose. Perhaps in rare cases, this might be true. However, most brokers don’t engage in this type of activity. Keep in mind, doing something like this exposes them in a major way. If a broker routinely trades at prices that other brokers have not traded then you’ll eventually see some arbitrage algos stepping in to take advantage of what they view as ‘free money’. In the end, the broker stands to lose a lot!
What is Stop Hunting
Having said that, brokers don’t usually actively try and trigger stops, but there are market participants that do, and they do it often.
The reason behind this is because traders that are trying to execute large positions often have trouble filling their orders without moving the price against them. This is simple supply and demand. However, if the price is already heading toward an area that is likely to have a lot of supply, then all a trader needs to do is ‘nudge’ the price further to trigger stops. This way the trader gets filled at a good price and has access to a lot of liquidity. This is the reason why new traders often get stopped out, and then the price ends up rallying in the direction they expected, in a major way.
How to Avoid Getting Your Stop Hunted
Simply put – don’t put it in an obvious place.
Probably the most common area a stop gets placed is above an important high (vice versa in a bullish case). This might be the session high, yesterday’s high, etc. Another place might be just below support or above resistance. If many market participants are watching a certain level, and it seems to be holding, then it will be obvious that stops will be accumulating in around that area. The same goes for moving averages and trendlines.
Take a look at the hourly chart of XAUUSD above. Let’s run through what is happening here.
- Support has been identified at $1490.
- There is further support from the psychological $1500 price point.
- One single bar takes the price from $1520 to a low of $1480 triggering stops in the process.
Note the bar that triggered the stops, it is the largest bar in play. This is common because when stops are being triggered, the market is heavily biased in one direction. This is because more sellers are trying to liquidate (getting stopped out) then there are buyers. Recall that buyers will place their orders below an important support level, in this case below $1490.
I should take a moment to point something out here. Often in articles such as this, the author will cherry-pick a chart to make an example. This is not the case here. I literally opened my platform and this was the first thing that I saw. Didn’t need to move the chart around, and it was already on the hourly time frame. It just happens that often so trying to finding an example is not very difficult.
There is another advantage here for experienced market players. Not only do stops get triggered from long positions, often bearish positions get initiated. After all, some major support was broken and there was strong downward momentum. This is another reason why it is important to recognize when a stop run is taking place. It might just save a trader from selling the bottom.
Know When a Stop Run is Taking Place or Areas Where One Might
Good traders train their eyes to look for areas where stops might be placed on a chart. Then, a stop can be placed away from that area. Better yet, an experienced trader might just wait for that stop to get triggered and enter there. If you’re someone that does that, congrats, you’ve taken your trading to another level.
I’ve heard many traders complain about their stops getting triggered and this is the best advice I can give. If your stop often gets triggered, you’ve figured out where everyone else is also putting their stops – use it to your advantage.
A Good Tool for Deciding Where to Place Stops – ATR
It stands for Average True Range. Similar to a moving average, the user can specify exactly what period to measure.
Most trading platforms will default to 14. To put that into an example, on a daily chart, that means the last 14 days. So the indicator looks at the last 14 days, takes an average of how much price has moved each day and spits it back at you. By no means is this perfect, but it gives you an idea of how far the market can go.
The important thing is to take the ATR of the time frame you’re trading, not the time frame you’re analyzing your setup on. Let’s take a look at the same chart, but how ATR plays into it.
In the hourly chart above, let’s say a trader identified that support is holding at $1490. The price is also back above $1500 which has psychological importance. The trader then sees resistance at $1509, and on a break, decides to get long.
The ATR on an hourly chart at that time indicates an average range of $5. The important thing here is knowing how long you plan to hold the trade. If you’re only planning on holding it for an hour, then a $5 stop will work. However, if you’re planning on holding it for a day, it’s better to take a look at the average range on a daily chart. In this case, that is a $22 stop.
To get an idea of where price can go, the average true range indicator is very useful. Keep in mind, it is more effective in combination with other indicators.
An Example of Using ATR
For example, if Gold prices are down $10 on the day already, then typically, the downside risk is another $12 ($22 – $10). The keyword here is typically, these are averages after all, not a true indicator of what is going to happen next.
If you happen to see a strong support level that is say, $14 lower, then you can put your stops just below it. Considering the average range, there is a good chance it won’t get triggered.
On the other hand, if you see support $2 lower, there is a chance it will get triggered, once again, considering the typical ranges.
Some of my best trades have been when the price is at one of the average range boundaries and I’m able to identify that a stop run is taking place. I usually look to fade these type of moves. I feel more confident it there is one more thing lining up. For example, some RSI divergence, or it is near the end of the session and I expect volatility to die down as it typically does.
It is certainly a good tool when used right and in combination with your other tools.