Whilst stop losses and profit targets might be two of the most elementary concepts in Forex trading they are still, no doubt, two of the most important and yet often misunderstood concepts.
Almost all mechanical trading systems use stop losses (although not always 'hard-stops') and stop losses are pretty much essential when one is trading using all but the lowest leverage. These stop loss functions are pretty much well understood, however what is less understood is how the use of 'tight' stop losses degrades the performance of almost any trading system. It is true that "a good trade rarely goes to far against you" as the old saying goes, but it appears to me that most retail traders don't understand just how far against them a good trade can go and still be a good trade. Most of the "advice" I come across from so called market "gurus" seems to wildly underestimate how large stop losses actually need to be in order to be effective.
Unlike stop losses, profit targets are by no means essential, at least they're not if the system is a trend following one. In fact, I would argue that the majority of good long-term trend following systems do not use fixed profit targets and aim to take as much profit as the market will give them, rather than a fixed amount. The smaller the profit target the more chance the trade has of being successful. Since one is very unlikely to ever be able to pick a market's top or bottom a small profit target can turn a 'bad' trade into a successful one. This does seem to be commonly understood, however, as with stop losses, just what is and isn't a suitable profit target doesn't seem to be so widely understood.
The Market State and Stop Losses and Profit Targets,
It doesn't matter what trading strategy one uses, it can only be successful if the market is in a favourable state for it. And what is and isn't a suitable stop loss and/or suitable profit target is no exception; that too depends on the market's state. Broadly speaking, a market can only be in one of two states; it can either be relatively stable (i.e. flat) or it can be trending. When the market is in either of those two states then it can be either relatively quiet or it can be volatile. So we therefore have four different types of market –
Trending & Quiet
Trending & Volatile
Stable & Quiet
Stable & Volatile
Trending & Quiet: Trend followers love trending and quiet markets. When the market is moving in a clear direction without to much volatility it is in the ideal state for mechanical trend following systems. When the market is in this state a mechanical trend following system can work with a relatively small stop loss and produce good risk to reward ratios. However, the lack of market volatility means that swing-trading systems don't work well. Systems that 'fade' the trend with profit targets are particularly bad as they often miss their targets as the market continues to move against them and trend following systems with profit targets, whilst they do work thanks to the trend, fail to take full advantage of the ideal trading conditions.
Trending & Volatile: Trending and volatile markets are far more difficult for trend followers to trade than trending and quiet markets. Attempting to trade with the trend on markets that are in this state is sometimes successful, providing the stop loss used is large enough and trend reversal signals aren't triggered easily. Using a trend following system with a 'tight' stop loss on a trending but volatile market is disastrous – you will be stopped out and lose when you're right and when you're wrong. A mechanical trend following system with a tight stop loss on a trending and volatile market will produce a string of small losses and very little else. Swing trading systems and systems with profit targets tend to work well on trending a volatile markets thanks to the volatility – the existence of the trend isn't ideal for swing trading but, providing there is enough volatility, swing trading systems are nevertheless still fairly successful on markets in this state.
Stable & Quiet: Stable and quiet markets aren't suitable for any type of trading system. With little volatility and almost no trend it's difficult to make any money. However, due to the spread, it's still easy to lose money! One should simply avoid trading any market in this state.
Stable & Volatile: Stable and volatile markets are ideal for swing trading but don't work well with most mechanical trend following systems. However, trend following systems with reasonable 'profit targets' often work well on these market conditions. Even though there may not be much of a trend, with enough volatility a reasonable profit target will usually be hit. The trading system component that causes mechanical trading systems to fail on stable and volatile markets is to small a stop loss; on these types of a markets using to tight a stop will usually doom any system to failure, whether it be a trend following system, a swing trading system, or whatever.
The Effects of Stop Losses and Profit Targets,
Of the four market states only three are suitable for any kind of trading strategy. Out of those three states two require fairly large stop losses due to the volatility. And in two of those three of market states trading systems perform well with profit targets. We can therefore say that in two thirds of tradeable market conditions mechanical systems with reasonable profit targets and fairly large stops losses perform best (although whether any one of those three states is actually more common than any of the others depends upon the market in question).
