Friday, April 6, 2012

Improving R:R via moving your stop loss

I stumbled on this idea over the last week and decided to use it with my last AUDUSD trade.

It's conventional for price action traders to place their stop loss at the high or low of the price action signal that they are trading. Sometimes, though, the size of these price action signals can be huge. In other times, momentum can swing against you so strongly that it becomes prudent to leave the market earlier.

As an experiment, I'm deciding to place my stop loss 25% from the high or low of the price action signal. As you can see in the image below, I'm using the fib tool on MetaTrader 4 to determine the 25% mark. 23.6% is close enough. My logic is that if price is within 25% of your stop loss, the likelihood of your SL getting hit is extreme. Why wait when you can leave the market earlier and cut your losses?

Not only that, but tightening your stop loss provides a disproportionate benefit to your risk-reward ratio. Suppose you have a trade with an initial 1:1 R:R. If you tighten your SL by 25%, your R:R is now 0.75:1, or 1:1.33. You've increased your reward by 33% while sacrificing only 25% of your SL. This opens new trading opportunities in tighter markets.

It is a very aggressive form of trading. It is entirely possible for your new, tighter SL to be hit before price returns in your favour. In such a case, a winning trade becomes a loser.

As a quick backtest, I initiated 17 orders on XAGUSD (silver) during 2010 and 2011, focusing on pinbars at levels of support and resistance, with a minimum of 1:1 R:R using the tighter SL. 11 orders were successful. The backtest showed an expected return of 29.4% per order at 1:1 R:R.

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