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
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
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.
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
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.
Stop Placement: Other Stop Locations
The following make for good stop locations.
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
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.
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.
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
Written and copyright © 2009-2013 by Thomas N. Bulkowski. All rights reserved. Be nice to your kids. They'll choose your nursing home.