Last updated on November 4th, 2020
Traders will obsess over their trade entry but won’t give a second thought to where they will place their stop loss whether they buy or sell or instrument.
One huge issue is that many traders will place their stop in a location where the trade is still valid because it means they can have a larger position size.
You probably recognize this type of protective stop loss:
The textbooks will tell you to place your stop loss right under support because if support breaks, your trade is no longer valid.
It will also allow you to use a higher position size which to most traders is something they support because they are under capitalized.
The problem is that this protective stop ignores basic fundamentals of how markets operate.
Breaks Don’t Always Invalidate Your Trade
In the example long position example above, price came down to support, formed a trading range above support and then took off to the upside. It’s a perfect example of a continuation play but rarely do we see such clean levels in the real market.
The market is not an orderly arena and there is a lot of “noise” in the market that you must account for. When looking at obvious levels for your stop loss order, you should be expecting that attention will be paid to it by many traders especially those who can really move the market.
Novice traders (and more experienced as well) will use these textbook locations and a cluster of stops will be sitting ripe for the pickings.
This is what a more accurate representation of these zones will look like:
What occurs is probes below the lows and the clearing out of stops sitting right below support. How often has that happened to you?
Think for a moment what happens at these levels:
- Traders positioned long are taken out and their stops (sell stops) get triggered
- Astute traders buy these flushes below support gaining a positions at a favorable price
- Traders still holding longs get the benefit of stopped out traders buying back in which propels their trade into profits.
This is the natural evolution of price and as a trader, you should seek to avoid these flushes by placing your stop in an area out of the way of the natural movements and volatility of price.
Use Rhythm To Place Your Stop Loss
We can never know what is to come in the market but we can easily see what has occurred. Using this type of knowledge can give you an objective stop loss placement as well as respecting current rhythm (volatility) of the market.
This will force you to use smaller position sizes which many traders will take issues with.
Question: If your order executes and are flushed out of a trade and the setup is still valid, will you reenter?
If you answered “Yes” to that question (which will depend on your trade plan of course) have you added up the cost of the trade and the loss (plus the potential second loss) to see if close stops cost you more in the long run?
Markets have a “usual” ebb and flow (which can change depending on who is involved in the market) and respecting that will have your stop in a position in tune with the market.
1. Measurements Of Market Swings
Markets have swings against the trend and then continue in the direction of the trend. These swings represent the current volatility of the market and can be used to place your stops outside of the natural flow. No method is perfect and I will highlight some issues after this graphic.
There is a swing highlighted by the green arrow where we have measured the distance in price of the swing. It is projected from the circled low and is a potential stop if a trade is taken short.
Price rallies, finds resistance (more evident on lower time frames but inferred from price action) and shorts obviously occurred. Price plots a higher low, rallies again and takes out stop at market price in the immediate area of the previous high. The second rally is part of the complex pullback but we wouldn’t know that at the hard right edge.
Stops are taken out and as evident by the large red candle after the stops were taken, traders pile into the short once again.
If you took the close stop, you were taken out however if you respected what a normal rally was in this market in the recent past, you’d have sat through some draw down only to be pushed quite hard into profit.
Here we have virtually no swings even close in size to the initial swing which can pose a position size issue depending on your account size.
A short sets up in the area of a former support zone (now broken) and if we project from the low prior to the rally, our stop is quite a distance away. Depending on your account size, this may be a trade you’d have to pass on if your plan calls for this type of stop loss.
Is this even a short trade you would take? If you are shorting a rally, are you shorting every rally or do you qualify the trade depending on the previous impulse move?
After support broke, it was a quick retest after a shallow impulse move plus having basing under a support break is not conducive to a strong continuation move.
As I mentioned, it’s not a foolproof stop loss method however it is quite objective and does respect the moves of the current market conditions. It can provide large stops which may turn off many traders but in the end, it is in tune with acceptable moves in the conditions you are trading in.
2. ATR Volatility Stop Loss
This is another objective and viable stop loss method using the average price range of the market you are trading.
I think it’s more objective than the previous method but you will still have to determine where you project the range from after the ATR has been calculated.
This is from the first example and the former stop is the white line. I have used the 20 period ATR calculation x2 and calculated the new stop from the closing price of the entry candle.
A few things to note:
- Trade entry is at the close of the candle that breaks the low of the pivot high candle (note yellow line)
- ATR stop loss is calculated from the closing price of entry candle
- Will you use the closing price, high or low price? There are arguments for all three
Whichever calculation you use it is imperative that you are consistent in all your trading.
Neither are low risk trading stops
You’ve probably heard the following “This is a low risk trading setup”. What does that mean?
There is simply risk.
The only way a trade can be “low risk” is if you are using a smaller risk percentage than you usually do. If you are jumping around in the risk percentages you are using, you are breaking one of the main rules of trading:
I personally would not use a different risk percentage unless it was part of the trade plan for a particular setup. For example, trading a failure test of highs may have an lower initial risk because I am expecting there will be another failure test before the trade gets going.
It is certainly not a low risk trade though.
If you are using the two methods outlined above, you may find you must sit aside on certain setups because in order to accommodate the larger stop, you must trade a lower position size. This obviously means your win dollar amount will also be lower.
The bottom line is that these two ways of setting your stop loss are mostly objective, keep you out of the noise and more importantly, they respect the market conditions you are trading in.
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