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Stop placement is a difficult trading skill to learn and a lifetime exercise in frustration. Price bars overlap in all but the most dynamic markets, which means your positions will crisscross the same levels over and over again, before trending higher or lower. This sideways chop undermines stop placement when you're trying to protect a small gain and the big prize at the same time, because the two goals are often not compatible. In other words, it's easier to take a little money out of the market, than to hold on to a lot of it.
How often has this happened to you? You see a trade setup, and jump in at the perfect price. The position turns a profit in the early stages, but you wind up losing every penny because your stop gets hit, just before the instrument reverses and moves sharply in your favor. Fortunately, you can avoid getting shaken out of good positions by using one of two radically different approaches to stop placement:
Apple rallies to 133.50 in early May and pulls back for nearly three weeks. It surges back to the high on May 26th and breaks out the following morning. This price action initiates a new action-reaction-resolution cycle that can be managed easily on the 15-minute chart. The buying surge (action) stalls at 135 and gives way to a consolidation (reaction) pattern. We want to buy the breakout, within the sideways pattern, in order to take advantage of an expected followthrough rally (resolution) over 135. The first buy signal comes when the stock jumps out of narrow range (1) at 133 on May 28th. It's harder to trigger a failure swing when price shifts from a low into a high volatility state, so "short-term" STOP A is placed just below the NR7 bar. The next buy signal comes when the stock pushes above the two-day high at 135 (2). A fresh entry in response to that breakout is likely to lose money, no matter where the short-term stop loss is placed. The shakeout then continues for over a day, with price spiking lower four times. The fourth downdraft posts a slightly higher low (3), triggering a buy signal because it predicts that whipsaws are finally coming to an end. We take a fresh entry and place a short-term STOP B just under the small hammer candle, which should work nicely if our buy thesis is correct. The stock then gaps out of congestion, triggering a clean breakout (resolution) that signals our fourth entry. Placing short-term STOP C just under the level where the gap would get filled makes perfect sense because we expect an immediate momentum surge, in line with the dynamics of a resolution phase.
Most active traders place their stops in the same old places, so they become attractive targets for the smart money and their wickedly accurate computer programs. To keep that big target off your back, learn to avoid stops at common hot spots, like trendlines, round numbers, and moving averages. In fact, it's best to avoid stop placement at any logical level because they become magnets for stop gunning events, especially before price jumps in the opposite direction. These frustrating "rinse jobs" seem unfair to traders, but they're a fact of life in our modern markets. Hey, no one ever said this game was easy.
Stay in the trade as long as price action shows you're right, but exit immediately when proven wrong. Your stop loss needs to address this potential failure because each position has a price that smacks us across the face and tells us our point of view is no longer valid. For obvious reasons, this is the natural location for the stop loss, which is then modified through analysis of recent trading ranges, to avoid getting caught in a rinse job. In addition, your trading plan needs to confirm that stop placement matches your intended strategy. For example, if you're looking for a multiday move, pull the stop back and risk more capital in the initial stages of the new trade. Conversely, if you're planning on a quick scalp, press the stop against the advancing stock, futures contract or currency pair, and just take what the market gives you.
Divide your stop loss strategy into three risk segments: initial stop loss, trailing stop, and exit stop. Then, apply each technique at the appropriate time in the position's evolution. This three-step process forces the trader to identify the profit target before entering the position. As discussed in Chapter 2, each trade has an intended exit defined by the next support or resistance level, reduced by interim barriers. This is your profit target. In other words, your pre-trade analysis looks at prior swings and zeroes in on the price level you expect your position to reach within the intended holding period. Simply stated, profit targets are vitally important in the third and final stop phase, because they tell you when to shift gears and to aggressively protect profits.
The trading strategy for initial stop loss placement is very simple - put it where the pattern is broken, if price gets there, or apply the short-term strategy outlined in the Apple example. Every trade has a good reason, and a bad breaking point. For example, if you buy a stock because it drops into a trendline, the stop loss needs to go on the other side of the trendline because your assumption is proven wrong, if price hits it. Of course, this placement doesn't work all the time because modern markets routinely charge through trendlines, take out stops, and jump back across support or resistance.
These rinse jobs give us just three logical stop modifications:
The most reliable placement strategy identifies lower-risk entry prices that let stops stay outside the line of fire. Start by identifying support-resistance bands near the edges of common patterns. These price extremes serve two purposes. First, they'll tell you when your existing stop loss is in mortal danger. More importantly, they'll identify execution levels for new positions. These extreme entries match up with exceptionally tight stop losses that are out of harm's way.
Stop gunning is a good way to lose money if already positioned and a great way to make it when coming off the sidelines. Chevron sells off in a steady decline, finally gapping down (1) to 66 on June 22nd. Short sellers enter the rectangle pattern (2) in the next week and place covering stop losses just above resistance at 67.25. Price shoots through the top of the rectangle (3) on the first day of July, triggering those stops and filling the gap. The next hour's reversal signals a low risk short sale entry (4) because the stop loss now can be placed less than a point above the 60-minute high.
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