One more important note:
How many bars should we use to define the trend? We have used 200 bars in
the examples above. It is a compromise – not too much, not too little. If you
were to use only 20 bars, you would risk entering the short-term explosive
market movements which are not real trends as we have explained above. If
you were to use 500 bars, you would hardly find any currency chart with trend
drawdown below 20%. Before we show you how to systematically pick the best
trending pairs and time frames every day, let's look at how to use the trend
drawdown in the most important aspect of trading – using a Stop Loss!
Protecting against volatility
Look at the chart above. The trader who placed the Stop Loss right after
entering the market deserves great applause but the problem is, the Stop Loss
is too tight! Give the market enough space to breath or the Stop Loss will be hit
very quickly.
Some traders use a fixed number of pips, something like 50 pips or 100 pips...
this is bad! Stop Loss has to reflect the current market volatility. Ask yourself:
“when did the price go as deep as my Stop Loss?” If it has happened several
times in the current chart, why would you think your Stop Loss will not be hit
now?
The ideal Stop Loss should be greater than the trend drawdown.
Listen to the market, not to the pips. In the example above, the Stop Loss
should be at least 233 pips. Too much? Well, use a smaller lot size. If you trade
1 minilot and $233 is above your risk tolerance, then use microlots. Or don't
take the trade. The worst thing you can do is use a small pip value just because
you want a small risk. Actually, you would risk more because if you don't give
the market enough space to breath, the Stop Loss would likely be hit regardless
of how good your trading system (or reliable the trend) is.
You would do well if you would use the trend drawdown + 1 pip as the pip
value for the Stop loss (233 + 1 = 234 pips in the example). If you want to
increase the success rate but on the other side, increase the risk when
compared to the profit potential, your Stop Loss should be set at a much safer
1.5 x trend drawdown.
Stop Loss = 1.5 x trend drawdown = 1.5 x 233 pips = cca 350 pips
Some traders would prefer even 2 x trend drawdown = 466 pips. Such Stop
Loss would be safe enough from the wild market. It's all about statistics.