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Bulkowski's Stop Placement

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My book, Trading BasicsTrading Basics: Evolution of a Trader book., pictured on the left, has an entire chapter dedicated to stops, starting on page 41.

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This page is one of two on stops. The second page (part 2) is a study that reveals how often a stop is hit and other vital details.

Correct stop placement need not be an art but a science. This page shows several ways to place a stop loss order to minimize the chance of being stopped out (your position sold) and to maximize profits while taking minimal risk. For more information see pages 69 to 84 of the book Trading Classic Chart Patterns and read the following...

Stop Placement: What I Use

I always calculate a volatility stop before trading a position. Then I check for an opportunity to move it closer to, or sometimes farther away from, the current price, depending on what appears on the chart. If I see a support zone just below price, then I may move the stop to just below that. Usually, if price does pierce the bottom of support, it will continue lower. So, I want to exit my position immediately instead of waiting for it to hit my volatility stop. Sometimes, I will park the stop below a minor low or Fibonacci retrace, so I look for those also. But mostly, I rely on a volatility stop for the vast majority of my positions.

Stop Placement: Minor Low Stops

Shows a minor low for stop placement

The figure shows a common stop placement technique. When price makes a new high, raise your stop to just below the prior minor low.

For example, point A is a minor high and point B is a minor low. Suppose you bought the stock at point D. Price has climbed to A before retracing to B. When price at C climbs above the minor high at A, then place your stop just below B.

This technique works because peaks and valleys (minor highs and minor lows) act as support and resistance zones. When price moves back down, it often stops at the price level of a prior peak or valley. A stop placed below the valley will stop you out only if price continues down. That's how it's supposed to work. Most often, though, price will resume the rise before hitting the stop.

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Stop Placement: Volatility Stops

What happens if the current price is at 15 and the prior minor low is at 10? If price were to drop back, you'd give away 30% of your profits before the stop loss order sold your position. This situation often occurs during straight-line runs or in low priced stocks in which a small price move represents a significant percentage change. That's where a volatility stop comes in handy.

I read about this in Perry Kaufman's book, A Short Course in Technical Trading. The idea is similar to my beta adjusted trailing stop (BATS) that I introduced in an article for Technical Analysis of Stocks & Commodities magazine in January 1997. Stop placement was done using beta (a measure of volatility) and the current price.

In Kaufman's technique, compute the average daily high-low price range for the prior month, multiply by 2, and then subtract the result from the current low price.

The following table shows an example based on Exxon Mobile's stock (XOM) during July 2005.



The difference column is the intraday high minus the low. The average of the differences for the month is $ 1.15. Multiply this by 2 to get the volatility, or $2.30. Based on the volatility of the stock, you should place your stop no closer than 56.45. That's $2.30 subtracted from the current low (58.75 on July 29). If price makes a new high, then recalculate the volatility based on the latest month, multiply it by 2 and subtract it from the current low. This method helps you from being stopped out by normal price volatility.

Recent testing has shown that a multiplier of 2 is best (it used to be 1.5). Also, the look back should be 22 price bars. That is about a month's worth of price data that you average.

The average high-low volatility measure (HL) performs better than the average true range (ATR, which includes gaps, whereas the HL method does not) and better than standard deviation. Standard deviation performed the worst of the three methods in nearly all of the tests.

For the test, I used about 100 actual trades I made from 1/1/2003 to end of 2005 and compared the performance of the three methods using various parameters to my actual results. I found that when using the HL method (with 2x multiplier and 22 bar look back), the average give back before being stopped out after price peaked is 6.88%, which is less than the 10% maximum I consider acceptable. The HL system made the most money and improved on the profitability of the trades 48% of the time.

Unfortunately, all of the stop methods tended to take you out of the best performing trades prematurely, so you can't use the method as the ONLY way to exit a trade. Discretionary timing the exit improved performance substantially. That means correctly choosing when to use a volatility stop and when not to is vital.

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Stop Placement: Other Stop Locations

The following make for good stop locations.

Shows a gap and horizontal consolidation region as a stop location

Stop Placement: Gaps

The above picture shows two additional stop locations. The left image shows a price gap. Notice how the minor low at A stops above the gap. Providing the gap isn't too wide (to keep the potential give back small), a good stop location is a few cents below the lower side of the gap at B.

In my book, Encyclopedia of Candlestick Charts I studied rising and falling windows (gaps). The above chart shows a rising window. Anyway, in a rising price trend, gaps provide overhead resistance just 20% of the time, and in a falling price trend, it lends support 25% of the time. Both measures are from bull markets. For more information, see page 11 or read the chapters on rising windows (page 903) or falling windows (page 898).



Stop Placement: HCRs

HCRs are horizontal consolidation regions. They are small knots of price congestion like that shown in the above chart. HCRs usually have flat tops, flat bottoms, or both, or horizontal movement that shares a common price. Place a stop a few cents below the HCR, at C, like the figure shows.

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Stop Placement: Round Numbers

Price often pauses or reverses at round numbers. A round number is 10, 15, 20, and so on. Novice traders don't place a stop at 9.93, they place it at 10. Thus, oddball numbers like 9.93 makes for good stop locations. Let everyone else get stopped out at 10 while you remain safe a few pennies below.

Stop Placement: Chart Patterns

The apex of ascending, descending, and symmetrical triangles are common support and resistance areas. They make for good stop locations as do the bottom of many chart patterns. Often, price will rebound before piercing the bottom price level of a chart pattern.

Stop Placement: Fibonacci Retracements

Fibonacci retracements make excellent stop locations. Look at the below figure for an example. When price swings from A to B, it often retraces (drops) a portion of the prior rise. In this example, the retrace is 50% of the rise from A to B.

Shows a Fibonacci retrace stop

Measure the swing from the prior minor low (A) to the prior minor high (B). Multiply the distance by 62% and subtract it from the price of the prior minor high. Place a stop just below the resulting value. You will find that price often retraces 38%, 50%, or even 62% of the prior rise. If price drops more than 62%, then price is likely to continue moving down. Thus, the 62% retrace amount represents a good stop location.

More recent testing shows that a 67% retrace will keep you safe two-thirds of the time.

-- Thomas Bulkowski

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See Also

Written by and copyright © 2005-2019 by Thomas N. Bulkowski. All rights reserved. Disclaimer: You alone are responsible for your investment decisions. See Privacy/Disclaimer for more information. Some pattern names are the registered trademarks of their respective owners. Be nice to your kids. They'll choose your nursing home.