How do I know where to put my stop?

Good day traders, Today I want to go over an article with you about STOPS and their use and more importantly why I don’t like them.  I greatly appreciate the emails I get from others and below is an email from a fellow trader. Please read this first and we will get right into this topic:

Michael,
This is a serious question you might want to address in the trading room, or maybe write an article about it. Most of the so-called forex teachers have drilled into my head that it is important to set stops, and suggest that the position of stops is critical in that the stop limits the amount of risk for the trader. However, it has been my experience that this practice only enriches the broker, for I have more often than not been stopped out only to see the price reverse and move to the point where I would have enjoyed a good profit if I had not been stopped out. You have indicated in the trading room that you have had similar experiences. A few evenings ago I noticed that Tim set a wide stop for a relatively small profit target, and I asked him about it.  He stated that he just tries to set stops where they make sense on the charts, without regard to a ratio between stop and target. I know none of us want to suffer catastrophic losses, but continual small losses have the same effect. So my problem, and that of many traders, is how do we determine where to set a stop to prevent undue losses, but at a point where we are not just surrendering pips to the broker. I know you’re too busy to answer each email, but if you could deal with this in an article, or a special training video, or in the trading room, it would be of great value to we who are struggling to improve our results. I appreciate you greatly, both for your trading skill, your care for each of us, and the example you set in your personal life.
Thanks,  Fellow trader (name withheld by request).

OK, we have said before that stops are your friend, they are there to protect you from loosing your account, yet many of you have heard me say I am setting my stop where I DO NOT think the market will go. I look at stops with a love/hate relationship.  Death, by a thousand small stops is very possible. We do have to give our trades some breathing room and yet also want to protect ourselves from disaster scenarios. There are several different ways of looking at this. One trader I met said that he back tested his trades (and forward tested too) and found that if he just gave them an extra 20 pips of room, 94% of his trades would hit the targets WITHOUT getting stopped out.  I took that to heart!  Lets take a few scenarios into consideration:

Number one:  You have identified a pair in an uptrend, its pulling back to the Ma’s with a level of consistency and you want it long.  So, you stalk your entry and when price pulls back to the 15 min river and starts to bounce on a one or a 5 min buy setup, you take it long and immediately place a stop under the previous 5 min candle low.  Price starts to follow through and your up 10 pips and feel happy, GO BABY, you say, as you pat yourself on the back for a job well done.  Then, all of a sudden price stalls, dips back down to your stop, takes you out and goes LOWER. So, you congratulate yourself on sticking to your plan.  Only to watch it set up another one minute or 5 min buy and price starts to ROCK, in fact, it never looks back and before you know it, it is up 50 pips and you are NOT on it!  How do you feel?

Number two.  You have identified a short opportunity, and want a bounce to sell into.  A major shelf had given way. Price was way to far extended below the Ma’s so you waited for the pair to come right back up to the bottom of the broken shelf. It sets up a nice looking 5 min sell bar and you enter short. This time the 5 min sell corrects almost immediately and you see a RBI and say to yourself, I am not going to stop out this time, only to watch it fall 50 pips in my direction!  I’m standing pat! Price continues to move up, taking out the top of the shelf and slowly grinds higher and higher, putting you deeper and deeper in the hole. UGH!!! What to do?

You are not alone! This is the trouble that plagues every trader, the times you stop out, you were right and the times you don’t you were wrong. Or worse, you adhere to stops constantly and suffer death by a hundred or a thousand small stop outs, till your totally discouraged.  How do you know when to stop and when NOT to stop, that is the question.  This is a tough call and I wish I had an easy answer.  I will provide you with the best answer I can muster, but this is NOT easy.  If trading was easy we would all be millionaires.  Its a tough business.

First I want to say that the broker (most often) is NOT really your friend and when you do put a stop into the system it is (under most circumstances) seen by “someone”. Think about it, you have just told them where you are willing to place an order. In this business it all comes down to commissions. The broker wants commissions and the broker that holds your order and DOES NOT PUT IT OUT to the market, wants the price improvement too!  They are taking the other side of your trade.  I can tell you this, there are MANY times I am stopped out to the pip (!)…. I mean HIGH OR LOW TICK and I wake up in the morning to see the trade moved over a  hundred pips in my direction and I am NOT on board, I will look at the charts and say, yup, that was me, the last trade at that level right before take off!  Folks, this is just plain agonizing. So, I think you can see why I HATE stops. They have cost me a bundle.

These days…. I do not like to use them unless I really have a solid, I mean rock solid buy or sell and I can clearly see that price should NOT return to the level or the entire move is invalidated.  Many of you in the room will hear me preach that I like to use the market maker strategy of building a position. Just like Livermore, the greatest trader of all time, who likes it at one price, loves it at another and HATES it at another, this is how I trade. I let the PRICE ACTION, tell me when I am wrong.  If I am taking a 15 min sell and I am FEARFUL of price running straight down to a target without me on board, I will often put an immediate third or more of a position on to the short side and then monitor the trade.  If I get a price improvement, and another sell setup I will ADD to the trade (as long as the original sell setup stop zone is not violated, that is, as long as price does not do a headfake, and start breaking out and attacking higher ground, where clearly the trade is just WRONG)  You see, if you have determined that your max. position size for any trade is 2 full lots and you break that down into 8  “bullets” of 25K each, you can in essence “dollar cost average” yourself into a trade at a better price.  This does 2 things, number one, it increases risk, but you have calculated that to see if the risk to reward is worth it.  Number 2, it can put you in a very good price, where you don’t need to much movement and you are quite profitable.

Now there are times that stops are very clearly visible to us, there are times I say:  “its either going to work or it isn’t”  This is usually visible on a screaming sell bar or buy bar. I will give you a few examples.  Notice on this chart the one hour sell:

I mentioned this as a decent trading opportunity in the room on MONDAY June 14th, 2010.  I said that right around this .7000 area, we should consider getting short. Time goes by and a sell bar develops. The candles themselves give you both the entry AND the stop. As time passes and the trade becomes profitable, we should get paid a portion and then manage the trade for further gains, or stops IN THE MONEY. Now take a look at this one hour chart of the euro dollar below:

Notice the screaming buy setup. This is pretty clear and speaks very loudly. I would NEVER want to see the price go below the hourly shelf if I was long. We might get a trade like this on a 5 or 15 minute buy and then manage it. As we see the price going up into minor psych levels, we would get paid a portion, adjust stops and enter management mode. If the price ever dropped below the shelf,  the entire trade would be violated.

Now, there are times you really want the trade, but stop placement is elusive. In that instance, we must look at the charts and calculate our risk.  Holding to the addage ” a great trader doesn’t just consider how much he can make on a trade, but how much can one LOSE on a trade. In instances like this, we need to calculate our maximum risk per trade.  What is that to you? is it $300?  Is it a thousand dollars??? What is the RR ratio? Are you risking one unit to gain 3, 4 or 5 units?

Example:  I KNOW that my consistancy is average 70% wins to losses….   I am risking 50 pips for a 150 pip target.  My RR ratio is 1 to 3. This is exceptable to me.  Am I willing to risk $500 to make $1,500?  Yes I am.  Ok, I will put ONE lot on this trade and set my stop and target and basically let it play out.  When I am up 50 pips, I will take some profits on a third, adjust my stops to break even and enter trade management mode.

Example:  This is a week looking 5 min buy.  Its counter trend.  what is the risk? HIGH??? one to one RR? I think I will pass.  These are the trading desisions we all have to make.  I strongly recommend planning our trade and trading our plan.

There are times, when building a position, that I DO NOT have a stop in mind.  Yet. but as time develops and the price action works out in my direction, then the stop becomes visible.  Its not always easy.  Bottom line is, you really have to come up with a plan that is acceptable to you, and that takes time and experience.  Roomies, if there is ANYTHING that is unclear in this…. Write down your questions and we will go over this in the room during a slow period.  I can show examples every day, and I would like to deal with CURRENT charts on our current day, with our memories fresh and our thought processes fresh. So, hit me up on this in the room for any clarification.  Targets are another issue, and we deal with this every day, I always show the targets and the WHY.  They can be based on many things, so I will not go over that in this article, but save it for another time.  Traders…. Till next time, Happy trading.  Michael Storm aka “Robinhood”