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 Fibonacci 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.