Depending on the technique traders use to find potential stop-loss levels for a trade, stop-loss orders can be divided into four main types: chart stops, volatility stops, time stops, and percentage stops. Another popular type of stop-losses that has seen the day of light just recently is the guaranteed stop, which will be discussed further below.
Chart stops are arguably the most effective and popular stop-loss type. They’re based on important technical levels, such as support and resistance level, trendline, channels, moving averages, or chart patterns, to name a few. The stop is then placed just below/above that level with the expectation that if it gets broken, the current momentum has shifted and the trade idea has been invalidated.
In general, a chart stop should be placed by looking at what the chart is showing us to be important technical levels and not by how much a trader can afford to lose. Therefore, a stop-loss order should be placed around an area where you’re not interested to stay in the trade if breached, allowing for an easy and fast exit out of the market.
Keep in mind that in times of high market volatility, wider stop-losses should be used to account for sudden price fluctuations. Giving a trade space to breathe avoids that you get stopped out by market noise – If you’re a shorter-term trader, placing a stop-loss with a 20 pips leeway provides you with enough room to withstand sudden price-spikes and regular fluctuations.
As their name suggests, volatility stops are based on the current or historical market volatility of the currency pair you want to trade. For example, if the average daily volatility of the GBP/USD pair is 110 pips, a trader would place his stop-loss simply 110 pips away from the entry price.
Popular indicators used in combination with volatility stops include the ATR (Average True Range) indicator. When using the ATR to identify the average volatility, traders can place a stop at 1.5x or 2.0x the ATR reading, for instance.
Time stops are stop-loss levels that are based on time. They’re especially popular among day traders who don’t want to hold their trades after the closing bells ring in London or New York, for example.
If a trader wants to close the trade by the end of the trading day, that’s also a time stop. If a swing trader wants to close his open positions by the end of the trading week on Friday, that’s a time stop as well. Time stops are very popular in Forex trading and are usually combined with other types of stop-losses.
A percentage stop is simply a stop-loss that is based on the percentage of a trading account. Unlike chart stops, percentage stops don’t follow important technical levels but are simply placed at a level that, if hit, limits losses to the pre-specified trading account percentage.
Bear in mind that percentage stops have no relation to the common trading practice of position sizing. Instead of using percentage stops, traders are usually much better off by using chart stops and sizing their position to risk only a small percentage of their trading funds. Your position size should be calculated based on the distance of your stop-loss, and not the other way around!
Last but not least, guaranteed stops are stops that guarantee to exit a position once the market reaches the pre-specified price-level. Remember our discussion about slippage and the widening of spreads? Guaranteed stops eliminate those risks completely by ignoring underlying market conditions.
Since your broker takes the liquidity and slippage risks of guaranteed stops, this type of stops usually comes at a small fee called the GSLO (guaranteed stop-loss order) premium. The fee is calculated by multiplying the GSLO premium (indicated on your broker’s website) by your position size. Also, bear in mind that not all brokers offer guaranteed stops.