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Trading notes 02/18/2011
One of the primary reasons a handful of traders can play the same setups and come up with different results is the way that they set their stops. A lot of traders who have been burned more times than not in their learning to trade journey will play their stops really tight to keep the pain in bite size increments that they can handle in single daily doses before quiting for the day or going back to simulation trading for a while until they figure out how to make those bites smaller or avoid losing all together. This behavior is in the top five reasons that most traders will continue to lose overall and not reach their goals in learning to trade. I teach on this probably more than anything in the trading room and in my private consultations with traders. I did the same thing myself early on and don't condemn anyone who struggles with it, but success lies on the other side of this struggle so decide now to get through it.
I am going to start using this space to start teaching through some of these issues in addition to my trade recaps.
Today we will be looking at the basics of stop placement when working around a level of support or resistance. Here is a chart from this mornings trading on the EURUSD where the market was coming down through one of its crunchies and allowing a common setup that we use in the room.
Price had been above the crunchy for a while and we came down through it giving an opportunity to get short below it with target potential down to the next crunchy below (see wider view if desired). Our first sell opportunity will come early after that break in most cases like it did at the red circle in the chart above. The issue that those traders who have conditioned themselves to take small stops to reduce pain run into is that at the first entry opportunity their stop will almost always fall within the area that often gets tested after a break. These means any backfilling to test the area will hit their stops and instead of looking at the way they handle their stop (remember they are already conditioned to bite size pain) they throw out the setup opportunity as not working for them. I equate this to playing chase with a hungry lion. If we stick our stops in the path of a test or tempt a hungry lion we are going to get eaten. This is the wrong approach and there are ways to use smaller stops and still play the same setups but they require looking at the setup in a way that focuses on where the stop should be to clearly show you that the trade is wrong. A wrong trade isn't the worst thing in the world either when the stop was placed correct because when that stop is hit it is often opening up a new trade opportunity in the other direction and we want to be with strength so that is good.
There is always a best place for a stop and that is beyond the recent highs or lows or totally outside the days trading activity (see chart above). There are no tests where price has not been. The second best place for stops is beyond a nearby swing, usually the immediate swing to the left. The minimum place for stops is beyond the level being tested or broken. If our stops are not set beyond the minimum level then more often than not they will be hit on a break type or a test of a level. The reason the minimum level is not the best, even though it is closest is that when playing off a level you usually get some pass-through activity beyond the level on the tests and if you are just a couple pips beyond a test level you can still be right on your setup and get taken out and few learning traders will re-enter in that same direction on the next signal, which is the proper action in those cases so they watch their original trade go on to where they had hoped without them in it. I always aim for the best place, which again is beyond all activity I can see on my chart around a level. This means that if my stop is hit then the market will have had to have found new strength in that other direction and I can capitalize on that even if the initial trade is a loss. If I were restricted to small stops, either by a small account size or an under developed pain threshold then I would have to make the trade more affordable for my small stop by waiting on a deeper pullback or test of the level being challenged. That is the solution for you too if you are struggling with getting hit on bite sized stops.
At least consider whether or not a more strategically placed stop will help make some of your trades more rewarding. Go back through some of your recent trades and see if getting the stop in that best position would have helped. Lastly if you take the time to set a strategic stop please don't mess with it once in the trade. It will take care of you on its own. You don't need to outsmart your method or let fear drive your trade for you.
If you need more detailed help on this be sure to ask in the room so we can go over it with live examples. It is always easier to learn that way. If you need to learn how to draw the crunchies then please see the video in the bulletin of the trading room.