Stop-Loss and Take-Profit Placement

The primacy of the exit decision

A trade has three components: the entry, the stop-loss and the take-profit. Of these, the entry attracts disproportionate attention because it is the moment of commitment. The financial outcome, however, is determined entirely by the exits. The average size of winning trades and the average size of losing trades, taken together with the proportion of trades that win, define the expectancy of the method. Two traders entering identical positions at identical prices will achieve different results if their exit rules differ.

Exit levels should be determined before the position is opened, when the trader is not subject to the influence of an open profit or loss. In MetaTrader 5, both the stop-loss and the take-profit can be attached to the order at the time of submission, so that the exit levels are in place from the moment the position exists. A stop-loss order is executed at market when the stop price is reached; under conditions of price gapping, the execution price may differ from the stop price.

Stop-loss placement

The stop-loss is placed at the price at which the reason for the trade no longer holds. For a long position taken from a swing low, that price lies below the swing low, because a move below it demonstrates that the structure on which the trade was based has failed. For a position taken against a support or resistance level, the stop lies beyond that level. For a position taken on the expectation of a continuation, the stop lies outside the range of normal fluctuation as measured by ATR.

The stop is not placed at the distance corresponding to the largest loss the trader finds tolerable. That approach positions the stop according to the trader's preferences rather than the market's behaviour, and results in stops that lie within ordinary price movement and are executed by fluctuation unconnected with the validity of the idea. If the structurally correct stop distance produces a monetary risk greater than the fixed percentage permits, the position size is reduced using the calculation in the previous lesson. If the required size falls below the 0.01-lot minimum, the trade is not taken.

Adjusting a stop-loss after entry

A stop-loss should never be moved further from the entry after the position has been opened. Widening a stop converts a defined and accepted loss into an undefined one, and it does so at the moment when the market is providing evidence that the original idea was incorrect. The decision is invariably made under the influence of an open loss and represents a refusal to accept an outcome that was agreed before entry.

Moving a stop closer to the current price as the position moves into profit is a different action. A trailing stop reduces the potential loss, or secures a portion of the open profit, in response to favourable movement. It is legitimate provided it is governed by a rule defined in advance, such as moving the stop to the entry price once a specified profit has been reached, or trailing it beneath each successive swing low. A stop tightened impulsively, in response to a minor adverse fluctuation, tends to be executed shortly before the position would have moved in the intended direction.

Take-profit placement and reward-to-risk ratio

A take-profit order is placed at a level that the market can plausibly reach: a prior support or resistance level, the opposite boundary of a channel, or the projection of a measured move. It is not placed at a fixed multiple of the stop distance simply because the resulting ratio appears favourable. A target that lies beyond the nearest significant obstacle to price will frequently see the position reverse before it is reached.

The reward-to-risk ratio is the distance to the target divided by the distance to the stop. This ratio determines the minimum win rate required for profitability. At a ratio of 1:1, the method breaks even at a 50 per cent win rate before transaction costs. At 1:2, the break-even win rate falls to 33.3 per cent; at 1:3, to 25 per cent. A favourable ratio therefore allows a method to remain profitable while being incorrect more often than it is correct. If the nearest structurally sound target is closer to the entry than the stop-loss, the ratio is below 1:1 and the trade is declined.

• Ratio 1:1: break-even win rate of 50 per cent.
• Ratio 1:2: break-even win rate of 33.3 per cent.
• Ratio 1:3: break-even win rate of 25 per cent.
• Transaction costs raise each of these thresholds; the general formula is break-even win rate = 1 ÷ (1 + ratio).

Premature profit-taking

The tendency to close a profitable position early, in order to secure a small gain, is among the most costly habits in trading. It is driven by the wish to convert an uncertain open profit into a certain realised one. Its effect is to reduce the average size of winning trades while leaving the average size of losing trades unchanged, since losing positions are allowed to run to the stop. A method with a positive expectancy can be made unprofitable by this habit alone.

Two structural remedies exist. The first is a fixed rule for partial exits, for example closing half the position at a predetermined level and allowing the remainder to reach the full target. The second is a trailing stop governed by a defined rule, which secures profit progressively while retaining exposure to a continued move. Either approach allows a measure of certainty to be obtained without reducing the average winning trade to a level at which the method cannot succeed.