Prior to each transaction an investor should analyze the price of the security and determine the amount of loss they are willing to assume to achieve a specific investment goal. Risk versus reward is an important concept and is usually based on the goal of a specific trading strategy. For example, a trading strategy that were the number of unsuccessful trades outweigh the number of successful trades would need to make more on winning trades compared to losses on losing trades to compensate for the negative win to loss ratio.
Each trade that is transacted should have a predetermined take profit level and a corresponding stop loss. A stop loss could be a percent loss based on price action or a fixed amount. Traders also often use support and resistance levels to create stop loss and take profit levels.
For example, the red arrow in the chart above points to an upward sloping trend line that represents support. On a close below this level, and traders who is long the EUR/USD currency pair might considered stopping out of a long position. The green arrow in the chart represents former resistance levels, which a trader who is short might consider using as a stop level.
A trailing stop level is another technique than an investor could use to manage price risk. In this type of methodology the investor’s moves their stop loss level as the market moves. The trailing stop loss could be a percent loss from current levels or a price level such as the lowest low over the past 3-trading days. The goal of the trailing stop loss is to assist the investor in riding a trend higher or lower and only exiting a trade when it is clear that the trend has turned around.
Along with a stop loss, an investor needs to target a take profit level. The take profit level helps define the risk reward profile that each trade assumes. Traders need to be cognizant that they do not change the profile just because the trade is moving in their favor. The trailing stop loss can assist with this process, if an investor re-evaluates their take profit level.
An investor can use chart levels such as support and resistance to help create take profit levels. For example, an investor who was short the EUR/USD currency pair shown in the chart above might considered buying back the currency pair when it hit support levels show by the red arrow.