Stop levels are an often overlooked aspect of trading, and yet they are one of the most important. Many traders spend hours, days and years searching for the ideal entry criteria, when simply they could adjust how they set stops to become more successful. Too often traders place stops at arbitrary levels which means they get stopped out before a real move happens. Increasing the problem, traders begin to narrow stops even more in order to reduce losses and in turn end up trading more low quality signals. Often problems can be related back to position sizing. A trader is will only willing to risk a certain amount of money on a trade, but they take an arbitrary position size. Determining proper position size is crucial in trading as position sizes should be adjusted instead of changing stop levels to only risk a certain amount of capital.
In forex trading stops and position sizing are very easily managed by most any forex broker. Same with any market (but the example below is a forex example, but the concept applies to all markets) so there is no reason for this to a problem.
If you can only risk $100 on a trade, don’t take 5 mini lots if the proper stop level is 50 pips away. Many traders take 5 mini lots anyway, and just make their stop 20 pips. This is a sure way to get stopped out more often than not. Instead, reduce the size of your position and keep the appropriate stop level. In this case, take 2 mini lots with a 50 pip stop. Remember that stop levels, in dollar terms will be a little different each time. Don’t use one stop all the time. For example, don’t use a 50 pip stop all the time just because it seems like a nice round number.
Stops should be placed at levels which indicate that the original trade idea was wrong. Chart patterns (that link will take you to my ebook on chart pattern trading) allow us to do this in a methodical way. We have a clear set up, which provides profit targets upon a breakout, but the pattern also provides a stop level in that if a breakout occurs in one direction, the opposite side of the formation offers us our stop level.
If a break downward occurs from a triangle chart formation, a break above the top of the formation shows that the downward break was false – our stop level should be here. This stop level can also be a stop and reverse. In this case this means we go from being short the pair, to long, with our original short position be stopped out and a new long position being taken. Whether a stop is used, or a stop and reverse method, is up to individual trader.
In another example, a head and shoulders pattern, once completed, can have a stop placed above the right shoulder. If rates move back above this shoulder we no longer have a classic pattern. We may still be able to trade the pattern but we want to stop our position out to see what develops.
Ranges are one of the most common chart patterns people look for, but one of the toughest to trade. Since they are heavily watched and easy to spot, many false breakouts occur, and since the profit target is roughly the same as the risk level, we need to be right more than we are wrong to make a profit. With some of the other patterns mentioned the risk is less than the reward when using proper profit target techniques and stop levels. When trading ranges trade for the breakout and set a stop just outside a recent swing within the range. This reduces the risk but keeps the target the same.
With all patterns, especially ranges, false breakouts occur, so have a stop in place. Multiple entries occur often as initial positions are stopped out. A trader can’t be a afraid to reenter a position if the trade was stopped out once before, but this should not be the case. We know false breakouts occur, they are part of trading. But if we stick to guns and trade according to our rules we will come out ahead.
Remember, false breakouts are just as tradable as real breakouts.
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For those in the US, have a great long weekend, and elsewhere in the world have a great start to your week.
Cory Mitchell, CMT
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