daytradingskills

We shall discuss here three major ways of placing stop orders.

1. Fixed amount

After determining the volatility of a stock, a trader places his initial stop loss order a certain fixed amount away from the buy price. One must not discount this technique for its sheer simplicity. For example, if you are buying a stock at Rs. 40, you may place your initial stop, say, Rs. 3 or any other amount below the buy price, based on your evaluation of the price movement and holding timeframe.

Many experienced traders prefer it to the percentage stop loss, where the trader merely uses a certain pre-decided percentage of price to places his stop order. The problem is that the arbitrary percentages totally ignore the price and market dynamics.

2. Volatility based

There are various ways to measure volatility; here we mention two easily available tools and see how they can be used to place stop orders. These are: the average true range (ATR) and the Parabolic SAR indicators. These are incorporated in most charting software packages.

Volatility from the ATR indicator

Many traders use the average true range for setting their stop losses. The reason is that the average true range is a good measure of volatility and market noise. High ATR values reflect high volatility while low ATR readings indicate range bound movement. Average True Range (ATR) is a moving average of true range calculated over a series of days. True Range is defined as the largest difference of:

Current high minus the current low
The absolute value of the current high minus the previous close
The absolute value of the current low minus the previous close

So, how can we use the average true range to calculate our stop loss?

It is simple – just subtract some multiple (say, 1.5, 2, 3 or whatever) of the average true range from the entry price. Most long term players use a multiple between 2.7 to 3.3 (which can equate to 5% to 15% stop losses). You need to experiment and find out what multiple works for you. For day trading, it will be a smaller number.

Volatility from the Parabolic SAR indicator

Another volatility based method is to use the Parabolic SAR indicator. It is shown as a series of dots placed either above or below a stock's spot price on a chart. When the dots are placed below the price, it is deemed to be a bullish signal, and the trend is expected to the upward. Conversely, dots placed above the prices signal a downward trend. It provides stop-loss levels for both sides of the market, moving incrementally each price bar.

The first entry point on the buy side occurs when the most recent high of the price has been broken; it is at this time that the SAR is placed at the most recent low price. As the price rises, the dots will rise as well, first slowly and then picking up speed and accelerating with the trend. This accelerating system allows the investor to watch the trend develop and establish itself. When the dots catch up with the price action, the trend has lost steam and a probably reversal in indicated.

The major advantage of the parabolic SAR is its ability to respond to changing conditions which removes all human emotion and allows the trader to be disciplined. This can be a wonderful friend of new traders. Its disadvantage: it becomes useless in a consolidating or choppy market.

3. Price pattern

Every price pattern has a trigger point that violates the pattern you intend to trade. The first stop loss can be based on this point where the current action violates the trade setup. Identify this price point in advance before making an entry, and place your stop just behind it.

For long positions, traders and investors usually place their stop loss somewhat below a price where the stock is likely to get support.  If the stock "bounces" every time it drops to Rs.73, that means there is support at Rs. 73.  A trendline is also a region of support.  If a stock is in a rising trend, and the trendline defining its rise is at Rs. 45, a trader might therefore set his stop loss order at Rs. 44.

If your entries are determined by the chart patterns and/or technical indicators, it is logical and consistent to allow them to decide the exit too. The beauty of basing entries and exits on the technical tools is that it is consistent and keeps emotion based actions away.

Stops are not meant to be hit

Always keep in mind that a stop order is a vital risk management tool to protect you against a bad trade. Stops should be seen as a protective devise. But it does not imply that you get out of the bad trades only through stop orders.

It is prudent to get out of a trade with a smaller loss as soon as you realize that it has turned bad rather than waiting and allowing the stop to hit mechanically (and taking a bigger loss). In day trading, a good trade is expected to move in your favor almost immediately. So, if your trade does not show definite positive sign within, say 3-5 minutes, you might consider exiting and wait for a better price pattern for entry. The bottom line is:

“If you are in a bad trade, you should know it well before your stop is hit.”

Use trailing stops to protect profits

Once a trade moves in your favor, get ready to place trailing stops to protect your profits – because markets are notorious for taking sudden turns. A good policy is to find the first opportunity to shift the stop to the break-even point. It aims to capture enough profits from the trade to make it risk free. Now you will not lose anything if the market takes a turn against you; of course, you are free to follow the profitable trend. A happy situation, indeed. However, never trail the price too closely; always allow room for volatility (meaning, average price fluctuations).

As the trade evolves, you may take guidance from support and resistance levels for moving your trailing stop. For example, the stock moves in your favor and then it congests for a few bars. When price again breaks even higher, you move the stop behind the last congestion level. This way, price needs to break the smaller support before it hits your trailing stop. You need to get more aggressive as the stock approaches your reward target. Change your strategy after the price has reached 75% of the intended target. Move the stop closer so that any small reversal takes you out of the trade.

However, no matter what strategy you employ to place the initial stop loss order, you must utilize “trailing stops” as a defensive strategy to protect profits in winning trades.