How Do You Calculate Stop-Loss?

Stop-Loss calculation strategies

The size of the stop-loss determines how much capital is at risk and affects the overall risk-reward ratio. If you set a stop-loss that’s too wide, you risk incurring significant and unnecessary losses, but set it too high, and you risk exiting a trade prematurely and limiting your profit potential. Calculating the optimal size is key. In this article, Traders Union will guide you through the various strategies used to calculate your stop-loss size, giving examples for each one. By the end, you should have a better grasp of which stop-loss strategy works for you. We will focus on four widely used methods for calculating stop-loss:

1. Percentage-Based Stop-Loss: This method involves setting a predetermined percentage below the entry point. It allows you to adapt to various asset prices and market conditions while maintaining a consistent risk threshold

2. Fixed-Pip Stop-Loss: When you employ this strategy you set a fixed number of pips as your stop-loss level. This straightforward approach provides a constant measure for risk across different trading scenarios

3. Average True Range (ATR) Stop-Loss: Leveraging the Average True Range indicator, this strategy focuses on market volatility. The ATR calculates the average range of price movements over a set period, which helps you adjust your stop-loss levels according to the prevailing market conditions

4. Trailing Stop-Loss: The trailing-stop method dynamically adjusts the stop-loss level as the trade progresses. It enables you to secure profits by automatically shifting the stop-loss upward as the asset's price increases, while still offering protection against sudden downturns

Although we are mostly focusing on using these stop-loss calculation methods for Forex trading, it’s worth noting that they can easily be applied to stock and cryptocurrency trading too.

Percentage-Based Stop-Loss

When using the percentage-based approach to calculating a stop-loss level, you should first determine the percentage of your account you're willing to risk on the trade, which is usually 1-2%. Then, multiply your chosen percentage by your account balance to determine the maximum amount of loss you can tolerate, as a monetary value. Next, divide the maximum loss by the pip value of the currency pair you are trading to calculate the stop-loss distance in pips.

Example:

Let’s imagine you’re starting off with an account balance of $100,000 USD. You open up a standard-lot-size trade on the EUR/USD currency pair. You assess your risk tolerance and determine that you can stand losing 2% of your capital, which amounts to $2000 USD. With EUR/USD, the pip value of one standard lot is $10 USD. So, you divide the amount of loss you can tolerate ($2000), by one pip ($10), which means your stop-loss distance is 200 pips.

Fixed-Pip Stop-Loss

A fixed-pip stop-loss involves setting a specific number of pips away from your entry price as your stop-loss level. However, the fixed amount you decide on should be based on technical analysis and not just a random number that you feel comfortable with. For example, if you were to open 1 lot on EUR/USD where 1 pip is equal to $10 USD, you might feel you don’t want to lose more than $50 USD and set the stop-loss at 5 pips below the entry price. However, the market doesn’t care about your feelings – you should use technical analysis and indicators to determine how many pips to set the stop-loss level at.

Example:

Let's imagine a trader initiating a $10,000 trade on the EUR/USD pairing. After conducting technical analysis, he identifies a crucial support level at 30 pips below the entry point. To implement a Fixed-Pip Stop-Loss, he decides to set the stop-loss level at 25 pips below the entry price to allow for a slight buffer. If the entry point is 1.1000, the trader sets the stop-loss at 1.0975. This way, if the market moves against his position and reaches the stop-loss level, the trade is automatically closed to limit potential losses.

Average True Range (ATR) Stop-Loss

The Average True Range (ATR) Stop-Loss strategy is a risk management strategy in Forex trading that leverages the ATR indicator to measure market volatility and adapt to price fluctuations. The ATR indicator is a moving average of the true ranges, typically from the past 14 days, and is made up of: the current high minus the current low, the current high minus the previous close, and the current low minus the previous close. It calculates the average range between high and low prices over a specified period to gauge volatility.

To implement the ATR stop-loss strategy, you set the stop-loss distance at a multiple of 2-3 times the ATR value. This approach ensures the stop-loss adapts to the prevailing volatility. When there is higher volatility, the ATR value increases, leading to a wider stop-loss distance and giving the trade more room to breathe. Conversely, during lower volatility periods, the ATR value decreases, tightening the stop-loss distance to reflect the calmer market conditions.

Incorporating the ATR stop-loss allows you to strike a balance between providing sufficient breathing room for trades to develop and maintaining effective risk management that adjusts to a changing market.

Example:

Let's look at the ATR stop-loss strategy with an example for the EUR/USD pairing. If we find the ATR for EUR/USD to be 0.0010, and decide to use a 3x ATR multiple for our stop-loss.

Then we calculate the stop-loss distance as 3 times 0.0010, resulting in 0.0030. So, if the entry price is 1.1250, we subtract the stop-loss distance of 0.0030 and get 1.1220. Therefore, based on the ATR stop-loss strategy with a 3x ATR multiple, we would set our stop-loss at 1.1220 for a trade with an entry price of 1.1250 on the EUR/USD currency pair.

Note:

It’s important to note that other technical indicators can be used to calculate the optimal stop-loss level in the same manner as we did here with ATR.

Trailing-Stop

A trailing stop-loss automatically adjusts the stop-loss level as the market price moves in a positive direction, making it one of the more dynamic types of stop-loss. Instead of setting a fixed price or percentage away from the entry point, a trailing stop follows the market price at a set distance, which allows potential profit to be locked in during favorable price movements while also limiting losses if there is a reversal. As the market price increases, the trailing stop moves upward, maintaining a pre-set distance below the highest price reached, but staying fixed if the market price moves downward.

Example:

Let’s say a trader is entering a long position on EUR/USD with an entry point of 1.10. He sets a trailing stop-loss of 30 pips. As the price climbs to 1.1050, the trailing stop-loss would adjust accordingly, maintaining a 30-pip distance below the highest price. If the price continued increasing up to 1.1100, the trailing stop would move up to 1.1070, which is still 30 pips below the current price. However, if the price starts declining, the stop-loss would remain at 1.1070 until the price reaches that level - unless it reverses and increases again. This limits potential losses and allows profits to accumulate during uptrends.

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Tips for calculating a stop-loss

• Consider Market Volatility: Assess the prevailing market volatility using indicators like Average True Range (ATR) and adjust the stop-loss level accordingly

• Avoid Extremes: Try to refrain from placing stops too close to the entry price, which can make them susceptible to normal price fluctuations, or setting them too far, which risks allowing excessive losses

• Incorporate Fundamental Analysis: Consider incorporating fundamental analysis into your stop-loss calculations, especially during events or news that may impact the market, to enhance the robustness of your strategy. Follow relevant fundamentals and adjust your strategy accordingly

• Factor in Support/Resistance Levels: Analyze historical price movements to identify key support and resistance levels to guide you in your stop-loss placement

• Follow Technical Indicators: Regularly incorporate technical indicators into your stop-loss strategy, ensuring that it aligns with current market conditions