WHERE TO PLACE PRE-EMPTIVE STOPS
Should we place stops – 10 pips from entry? At 3 times the ATR (average true range)? At the extremes of noise levels around support/resistance lines? When price crosses a SMA support? Must it be 10 pips – can’t it be 3 pips instead? At the last pivot point or 50% Fibo retracement? At the last swing high or low which shows clearly that the set up has failed? What about whipsaw? Should we put the stops 20 pips from or maybe 50 pips from such a point? Maybe we should not place a stop, and wait for price to rebound. Simply pick the most conservative stop that meets money management guidelines? …. Seriously??
There is no universal standard for putting stops, and every set up or strategy must have good logic (abeit sometimes subjective), for stop placement. Apply a universal stop, and what works with one strategy will prove disastrous for another.
STOPS ARE CLEARLY DEFINED BY LOGIC AND TRADE MANAGEMENT
Successful pre-emptive stop placement is dependent on 2 skills – our ability to associate the rationale behind the set up we are using with its proposed stop(s), and how we make a trade entry.
As an example – If our setup is a momentum motivated quick scalp with intended 5 to 10 pips profit target within 15 to 30 minutes, then preparing for a possible price retracement which shows a change of direction or shows overall momentum retarding, will indicate where the stop should be. Most likely we shall need a fixed value mental stop (eg. fixed stop of 3 to 5 pips from trade entry). Will a retracement of 3 to 5 pips be sufficient to show definitive change of direction? Does it matter? If the set up is to capitalise on impulse momentum generated by the market maker to take out obvious nearby stops within a 10 pip range, than a 3 to 5 pips stop is clearly compelled by money management guidelines. Momentum retarding becomes the main trigger – we don’t wait for definite direction change. If we widen the stop to 10 pips away, it may give price a chance to rebound in the desired direction. Great if it works, but what if it does not? We are gambling once we place a stop that is incongruent with money management guidelines, and the reason why we took the trade (ie. momentum ramp up that should be sustained by stop catching). If we maintain an open position after momentum slows down, and HOPE momentum will pick up again, we are gambling on faith. Continuous misalignment between stop loss placement and this driven scalp strategy will likely ruin our equity account.
On the other hand, if our strategy is to catch stops in a retracement move over the next 3 hours for 20 to 40 pips average profits, then our stop will likely be a certain number of pips below or above that major support/resistence level coinciding with price action (eg. a reversal hammer with a long tail bouncing off the support/resistance level). The trader may also consider the ATR value as well as money management guidelines (eg. 10 pips below the support if the ATR is 8 pips). Should the stop be 10, 20 pips away from the support / resistance level? That depends on the logic behind the setups we use and when we enter. If we take a trade after a hammer reversal with a long tail, complemented with a following higher low or lower high, we can set a small pip value (eg. 3 pips) from the support or resistance level. If price further bursts through a minor congestion in our favor, we can move the stop loss to the higher low or lower high. If price fails, ie. it retraces violently towards support/resistance, that means our setups (eg reversal hammer + possible 1-2-3) have failed, so why risk more pips at the support/resistance level in hope? Some would question whether we be entering at a premium price – does it matter? Assess the reward risk ratios of both options, weigh the value of risk mitigation, and make a decision. (By the way, I speak of setups in simple terms here to facilitate reading – but whether we even take an entry based on a “set up” depends on many factors – in the current example, this may include higher timeframe trend analysis, news release, whether price action has settled into a congestion/range or is likely to, estimated market liquidity.) Setup strategies can be covered in future articles. What we are pointing out is setting an optimal stop involves common sense regarding strategy and set up rationale, rather than just a “loss tolerance” money managemenet exercise.
NO STOP LOSS
No stop loss? I know at least 1 person who does not put stop losses and trades successfully. Some studies have shown that stop losses in certain market conditions actually impair longer term profitability performance. Perhaps he is wise in such areas. I personally do not put stop loss on mid term equity investments, but I have non-monetary conditions for hedging or closing such positions (eg. the company is not competing well in the industry regardless of stock price). As for Forex, this trader friend had been willing to take longer term trades, had been successful, so I do not argue against his results. But I trust I generally sleep better than him.
That’s one part of stop placement – it depends on the strategic logic of a trading set up under prevailing market conditons. How we enter a trade determines stop placement too – watch for that instalment in an upcoming article – Stops and Whipsaws.