Foreword: During trading, do you often find that prices reverse towards the take-profit point after hitting the stop-loss point? Or do you often see prices nearing the take-profit point, only to suddenly reverse to the entry point?
These situations can indeed be very frustrating. The explanation is simple: you have set incorrect stop-loss and take-profit points.
Prices frequently hit the wrong stop-loss points, while incorrect take-profit points are harder to reach. This often leads to traders making small profits and big losses.
Despite this, there are both losing and winning scenarios in the market. Some people consistently profit over 100 points. How do these experts set their take-profit and stop-loss points to lock in large gains?
Today, we will introduce a simple method commonly used by experts to set the best take-profit and stop-loss points—the STEP method.
01 Short Reversal Trade Example
Why do experts prefer the STEP method? Because it is applicable to almost any trading setup!
To better understand the trading strategy, I will explain these concepts using an example. Here, I have chosen a reversal trade, one of the main setups in the free price action strategy.
First, let's set up a simple trade.
As shown above: This is a short reversal trade setup. After a strong indecisive candle forms, we enter the short trade from the resistance zone.
At this point: Place the stop-loss above the high of the resistance and indecisive candle, and set the take-profit point above the next support zone.
Why set stop-loss and take-profit points this way? We will discuss this next.
02 The STEP Method
The STEP method provides a very easy-to-remember procedure for setting the best take-profit and stop-loss points for each trade.
First, let's familiarize ourselves with the basic steps of using the STEP method: • Stop: When identifying a potential trade, the first thing we need to do is determine the safest and best stop-loss point;
• Target: Next, we need to find out the best take-profit point. The price at this point should be easily reachable while also providing a good profit;
• Entry: The next step is to choose the correct entry point and ensure we have a good risk-reward ratio.
• Place: After setting the stop-loss, take-profit, and entry points, we can enter the trade.
Next, let's break down the STEP method more specifically.
1. Setting the Best Stop-Loss Point
When setting the stop-loss point, the first thing we need to do is ensure it is placed behind an obstacle. What is an obstacle?
Support and resistance zones
Nearby highs and lows
Psychological levels Going back to the trading example mentioned at the beginning, let's see why the stop-loss is set this way.
1. Support and Resistance Zones
We plan to short the USD/CAD currency pair. When looking for a stop-loss point in a short trade, the first thing to watch is the resistance zone (marked as 1 in the image). We use the resistance zone to secure a safe stop-loss position!
When trying to set a stop-loss, place it above the resistance (or below the support in a long trade). This setup provides a considerable advantage to our trade.
After entering a trade, retracements often occur. Sometimes, retracements can even exceed the entry point.
Most traders know the pain of closing a trade early due to a retracement, only to see the price move in the initial predicted direction afterward, leaving them unable to do anything.
Therefore, setting the stop-loss above the resistance means that the likelihood of the price hitting it during a retracement is low.
The reason is: resistance serves as an obstacle for the price, and minor price movements tend to fail when they encounter obstacles. Hence, placing the stop-loss behind an obstacle is crucial!
2. Nearby Highs and Lows
Besides setting the stop-loss above the resistance, we also need to set it above recent highs (or below nearby lows in a long trade).
When bulls lose control over the price, creating new highs becomes difficult, so setting the stop-loss above nearby highs provides extra protection (marked as 2 in the image).
At this point, we might realize (especially beginners): to achieve a better risk-reward ratio, we must adopt stricter stop-loss and take-profit levels.
But trading involves risk management, and we need to allow enough room for reasonable price movements to ensure that we do not lose a trade unnecessarily.
Successful trades usually go through retracements. Therefore, in a short trade, setting the stop-loss above nearby highs or, in a long trade, below nearby lows can provide additional protection.
3. Psychological Levels
Psychological levels form an additional obstacle, and we can sometimes use psychological stop-losses. These levels can be annual highs or lows or larger numbers like USD/CAD 1.0000.
These levels are significant because they act as psychological barriers. The market is driven by people who react to these psychological levels.
In the image above, we set the stop-loss above the annual high (marked as 3 in the image), expecting the annual high to act as a psychological barrier, making our stop-loss safer.
In summary, the key to setting the best stop-loss is to place it behind as many obstacles as possible.
2. Setting the Best Take-Profit Point
The key to setting the best take-profit point can be summarized in three words: look to the left. When searching for the take-profit point, look at the most recent area where the price stagnated to the left.
In the image above, the trading tool (green and red areas) shows the potential trade.
Why set the take-profit point this way?
To the left, we see that the price stagnated three times in the area marked by the blue line over the past few weeks. This area represents a minor resistance and thus an obstacle. We need to ensure the take-profit point is set before or at the obstacle. This is the simplest way to set a take-profit point.
3. Identifying the Entry Point (Risk-Reward Ratio)
Finding a good entry point is relatively simple, as it only needs to meet two conditions: matching the entry rules of the trading strategy and having a good risk-reward ratio. Generally, the rule of thumb for the risk-reward ratio is 1:2. For example, if the stop-loss is set at 50 points and the take-profit is 100 points, the risk-reward ratio is 50:100, which simplifies to 1:2.
In the example we used thus far, the entry point should be below the low of the indecisive candle. This is the most basic entry type, as it is quite effective.
Choosing this method to confirm the entry point lets us enter at a good price while maintaining a favorable risk-reward ratio.
Here, we set the risk-reward ratio to 1:2, meaning the take-profit is twice the stop-loss. In other trades, we can adjust the risk-reward ratio based on actual circumstances, but 1:2 is common.
4. Entering the Trade
After setting the stop-loss, take-profit, and entry points, we can enter the trade. If we follow the first three steps, our trade is essentially safe.
Some say finance is a gamble, but I don't think so. I believe it's more of a contest, much like playing chess. You never know your opponent's next move, but you need to read the board's direction and decide your next move wisely, maintaining balance in advance and retreat, and keeping a steady mindset.
Avoid greed and panic, and approach trading like walking through life—taking each step carefully. Don't chase overnight riches; instead, focus on a long-term plan. Set your take-profit and stop-loss points and seek steady progress, and you'll be on your way to success!
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