Tight stop loss is often seen as a bad strategy due to its high risk, but there are always two sides of a coin. Learn about the advantages of trading with tight stop loss in this article.

As a trader, it's important to realize that forex trading carries several notable risks. This is why you need to have a certain mechanism to limit those risks and ensure the safety of your funds. One of the most common options is to use stop loss orders, which can be useful in protecting your trades from losses. It allows you to manage your risk without having to stare at the computer screen all the time.

Using tight stop loss

However, setting a stop loss order is not that easy. You need to plan it well and place it in the right spot in order to take advantage of the tool. Ideally, it should be placed at a level that is wide enough to let the price fluctuate, but also tight enough to close your position at a minimal loss.

One of the common mistakes that a trader make is placing the stop loss too tight or too far from the entry level. Rather than helping you, such placements can drag you down and make you lose money. But what if I tell you that it's possible to make a greater profit with a tight stop loss?

Trading with a tight stop has a number of considerable advantages. Here are some of them:

 

You Can Improve Your Risk to Reward Ratio

In forex trading, you need to take some risks, and the amount of those risks depends on the size of your stop loss distance, measured in pips.

For instance, if you limit your risk to 50 pips in a EUR/USD trade and make your target profit at 150 pips, your risk to reward ratio is 1:3. This means, if you make the right prediction and the trade turns out to be profitable, then you will make 3 times more profit than what you risked at the beginning of the trade. To be more precise, you'll get approximately $1500 if the trade is profitable or you'll lose $500 if the trade loses.

Now, what if you lower your risk limit to 10 pips, but keep your target profit at 150 pips? Your risk to reward ratio will no longer be 1:3, but 1:15. This means you will get 15 times more money in a profitable trade! A pretty significant improvement compared to the previous example. However, this also means that the chance of losing money is much higher too. This is why the method is only recommended when you are so confident with your analysis. Although you might not encounter such circumstances often, this method can be extremely beneficial when the right time comes.

 

You Can Trade Larger Position Sizes

Tight stop losses allow you to trade with larger contracts. For example, let's say that you have a $20,000 balance in your trading account and you are planning to trade 1 standard lot. If you set your risk to 50 pips, then you are risking $500 or 2.5% of your total balance.

Now, if you decide to set a 10-pip stop loss instead of the initial 50 pips, you will only risk $100 or 0.5%. Assuming that your maximum risk limit for every trade is 2.5%, then you can open 5 standard contracts based on the 10 pips stop loss. This is actually more beneficial than the first option because diversification matters when it comes to trading. By opening multiple smaller positions, you'll get a better chance at making profits than if you open a single large contract.

 

You Can Use Pyramid Trading and Increase Your Profit

A tight stop loss can enhance the performance of pyramid trading, which is often known to boost profits. The main reason why the two methods are so compatible is the fact that your stop loss distance is very tight. Hence, it won't take very long for your trade to be profitable once you get the timing and the direction of the price movement right. Keeping the trade a safe distance away from the entry price allows you to open the next trades while riding the same price trend.

 

You Can Significantly Reduce Your Loss

Exactly like the core purpose of stop loss in forex trading, tight stop strategy can help you minimize your trading losses. Tighter stops mean lower losses, but remember to be careful when using this theory because financial assets are often volatile, so the prices can go up and down unexpectedly.

 

Watch Out for These Common Mistakes

In order to avoid getting too much loss from tight stops, here are the things that you shouldn't do when trading:

 

Setting the Stop Loss Too Tight

Tight stop loss can be beneficial, but you need to make sure that it's not too tight or too close to the entry point. First of all, know that price fluctuates all the time and the movements can be big or small, depending on the current situation and outside influences. If your stop loss is too tight, there's a chance that it will be triggered accidentally by these fluctuations, forcing you to close your position and leave the market before the price had a chance to recover.

When this happens, you will not only miss a golden opportunity to make a profit, but you will also lose money in the process because the trade is closed with a loss. So, if you keep placing your stop loss too close to the entrance, you'll end up losing your money little by little.

 

Placing the Stop Loss Based on Position Size

All assets are volatile, but each has a different level of volatility. For example, cryptocurrencies are generally more volatile compared to stocks. Even two assets of the same market like Bitcoin and Dogecoin can have different volatility.

This means you are not supposed to place your stop loss based on your position size. The truth is that these numbers actually have little to no effect when it comes to the outcome of your trade. Instead, you need to focus on studying the asset carefully and analyzing its market performance from time to time. Then, place your stop loss depending on the market's volatility and the amount of risk that you must bear.

 

Placing Stops on Support and Resistance Levels

Another mistake that a trader can make is placing a stop loss right on the support and resistance levels. This is not a particularly great idea because these levels often get broken for only a short time.

Let's just say that you open a long trade when the asset fluctuates around $20 and $23, expecting it to go up. If you place your stop loss at the $20 support level, it will easily get triggered when the price falls to touch it. Keep in mind that the price might go beyond the level a little, let's say, to $19.9, before surging back up again. If this happens, you'll lose the opportunity completely. Note that the same situation might happen if you go short and bet the price to drop. If you set a stop at $23, it will very easily get triggered before moving back down in your expected direction.

The better way to do it is to give a little more space and place the stop loss at least at $19.5 if you go long or $22.5 if you go short. But again, it should all depend on how strong the fluctuations are and the current situation of the market.

 

Summary

Trading with a tight stop loss is not always a bad idea like most people might think. From this article, we learned that there are many benefits that are worth considering. Although the risk is pretty high compared to other methods, you can see it as an opportunity to make a greater profit if you place it correctly.

At the end of the day, you need to do a lot of research and practice to sharpen your technical skill and master the art of trading with tight stop loss. Remember that each trade is different, so you should pay attention to the current market situation and weigh all the risks before opening a position.