Topic

Correctly determine your Stop-Loss

Topic Progress:

After this lesson you will know:

  1. How to determine a Stop-Loss level.
  2. What you should be aware of with Long and Short positions.
  3. How your personal attitude toward risk can affect your Stop-Loss.

Reading Time: 20 Minutes

The Stop-Loss is one of the most important elements when trading CFDs.

Not setting a Stop-Loss level can quickly have adverse effects on your current profit/loss due to unexpected market movements.

As a beginner, you should definitely take time to internalize the following 3 steps of the experts.

Step 1: Determine the volume

With this, we mean the volume that will be moved on the market. Try thinking of it in these terms:

With €1,000, at the actual exchange rate (29.01.2016 – 12:29) you would get $1,091.33. An increase in this rate of 1% would increase this amount to $1,102.24, and would represent a profit of $10.91.

Although an increase in any currency pair by one percent would be regarded as a very large jump, for your total investment of €1,000 you only see a return of €10.

A CFD is based on the idea of increasing your total trading volume, without having to increase your absolute investment.

The actual trading volume is always calculated using the following formula-

Volume = Number of standard contracts * position size * price

As a trader, you can only affect the number of standard contracts, also known as Lots, you wish to trade (here in blue).

The positionsize is always fixed (here in red) and depends on the underlying asset being traded.The price is determined by the market and can also not be changed by the trader (here in red).

A EUR/USD standard contract has, like most currency pairs, a positionsize of 100,000 units. Accordingly, the actual trading volumefor a single standard contract would be:

Volume = 1 * 100,000 * $1.08937 = $108,937

So far so good, the first step is now complete.

Important to note:
The trading volume is always a multiple of the actual market price!

Step 2: Risk amount with Long and Short positions

A good trader determines, based on a well-thought-out strategy, the amount he/she would be willing to risk on a position. In order to ensure a better understanding, this amount will from now on be referred to as “amount at risk”

Unlike most other financial products, the “amount at risk” with a CFD can be determined only by setting a Stop-Loss level.

A guideline for the maximum acceptable “amount at risk” is 3% of the total account balance!

Christopher Scharl: When I started trading CFDs, this calculation was a little too complicated for me. But once I understood, success in trading soon followed.

$10,000 as an account balance, would when following the 3% rule, mean a maximum “amount at risk” of $300.

Now it’s time to calculate the Stop-Loss price. Depending on whether you are investing in rising or falling prices, the Stop-Loss price will be higher or lower than the opening price.

Long Positions – rising prices

The “amount at risk” relative to the position size is subtracted from the opening price.

Stop-Loss = opening price – “amount at risk” / (number of standard contracts * position size)

Stop-Loss = $1,.08937 – $300 / (1 * 100,000) = $1.08637

Short Positions – falling prices

The “amount at risk” relative to the position size is added to the opening price.

Stop-Loss = opening price + “amount at risk” / (number of standard contracts * position size)

Stop-Loss = $1,.08937 + $300 / (1 * 100,000) = $1.09237

Important to note:
The Stop-Loss is influenced solely by the “amount at risk” and the number of standard contracts! Compromising the 3% rule means tolerating more risk, which can lead to higher profits, but also higher losses.

Step 3: Adapting to your personal attitude toward risk

The calculated Stop-Loss may not be appropriate/acceptable for some traders. There are two reasons for this:

  1. The strategy calculates a Stop-Loss that requires too high an “amount at risk”, meaning if the Stop-Loss is triggered the actual loss is not covered according to the strategy.
  1. The strategy calculates a Stop-Loss that requires too low an “amount at risk”, meaning if the Stop-Loss is triggered the actual loss is higher than necessary.

Solution:

1. Either the trader violates the 3% rule and is willing to accept a higher amount of risk, or they reduce the number of standard contracts.

Example:
A reduction of the number of standard contracts from “1” to “0.75”has the following effect:

Volume = 0.75 * 100,000 * $1.08937 = $81,702.75

Stop-Loss = $1.08937 ± $300 / (0.75 * 100,000) = $1.09237|$1.08537

Without reducing the number of standard contracts, the “amount at risk” must increase, in order to achieve the same Stop – Loss level of $1.09337│$1.08537.

Stop-Loss = $1.08937 ± $400 / (0.75 * 100,000) = $1.09237|$1.08537

Important to note:
Fewer standard contracts with the same “amount at risk” allow for more price fluctuations because the Stop-Loss is further away from the opening price!

2. Either the trader accepts a degree of risk under the 3% rule, or they increase the number of standard contracts. This will then pull the Stop-Loss level closer to the opening price.

Example:
An increase in the number of standard contracts from “1” to “1.5” has the following effect:

Volume = 1.5 * 100,000 * $1.08937 = $163,405.50

Stop-Loss = $1.08937 ± $300 / (1.5 * 100,000) = $1.09137|$1.08737

Without increasing the number of standard contracts, the “amount at risk” must decrease, in order to achieve the same Stop – Loss level of $1.09137│$1.08737.

Stop-Loss = $1.08937 ± $200 / (1 * 100,000) = $1.09137|$1.08737

Important to note:
More standard contracts with the same “amount at risk” allow for less price fluctuation, as the Stop-Loss is closer to the opening price!