Probably
just as important as knowing where to enter or take off profits is knowing
where to place your stop loss.
You can't
just enter a trade based on Fib levels without having a clue where to exit.
Your account will just go up in flames and you will forever blame Fibonacci,
cursing his name in Italian.
In this
lesson, you'll learn a couple of techniques to set your stops when you decide
to use them trusty Fib levels. These are simple ways to set your stop and the
rationale behind each method.
The first
method is to set your stop just past the next Fibonacci level.
If you
were planning to enter at the 38.2% Fib level, then you would place your stop
beyond the 50.0% level. If you felt like the 50.0% level would hold, then you'd
put your stop past the 61.8% level and so on and so forth. Simple, right?
Let's
take another look at that 4-hour EUR/USD chart we showed you back in the
Fibonacci retracement lesson.
If you
had shorted at the 50.0%, you could have placed your stop loss order just past
the 61.8% Fib level.
The
reasoning behind this method of setting stops is that you believed that the
50.0% level would hold as a resistance point. Therefore, if price were to rise
beyond this point, your trade idea would be invalidated.
The
problem with this method of setting stops is that it is entirely dependent on
you having a perfect entry.
Setting a
stop just past the next Fibonacci retracement level assumes that you are really
confident that the support or resistance area will hold. And, as we pointed out
earlier, using drawing tools isn't an exact science.
The
market might shoot up, hit your stop, and eventually go in your direction. This
is usually when we'd go to a corner, and start hitting our head on the wall.
We're
just warning you that this might happen, sometimes a few times in a row, so
make sure you limit your losses quickly and let your winners run with the
trend. It might be best if you used this type of stop placement method for
short term, intraday trades.
Now, if
you want to be a little safer, another way to set your stops would be to place
them past the recent Swing High or Swing Low.
This type
of stop loss placement would give your trade more room to breathe and give you
a better chance for the market to move in favor of your trade.
If the
market price were to surpass the Swing High or Swing Low, it may indicate that
a reversal of the trend is already in place. This means that your trade idea or
setup is already invalidated and that you're too late to jump in.
Setting larger stop losses would probably be best used for longer
term, swing-type trades, and you can also incorporate this into a "scaling in" method, which you will learn later on in
this course.
Of
course, with a larger stop, you also have to remember to adjust your position
size accordingly.
If you
tend to trade the same position size, you may incur large losses, especially if
you enter at one of the earlier Fib levels.
This can also lead to some unfavorable reward-to-risk ratios, as you may have a wide stop that isn't proportional to
your potential reward.
So which way is better?
The truth
is, just like in combining the Fibonacci retracement tool with support and
resistance, trend lines, and candlesticks to find a better entry, it would be
best to use your knowledge of these tools to analyze the current environment to
help you pick a good stop loss point.
As much
as possible, you shouldn't rely solely on Fib levels as support and resistance
points as the basis for stop loss placement.
Remember,
stop loss placement isn't a sure thing, but if you can tilt the odds in your
favor by combining multiple tools, it could help give you a better exit point,
more room for your trade to breathe, and possibly a better reward-to-risk ratio
trade.
