The Daily Market Forecast... stop placement

Today’s Lesson: Honing your stop placement.

Stops are mandatory orders for risk management. The big question is where to place them. Before we explore different methods, understand that per-trade risk is controlled as much by your position size as your stop placement. Wide stop = less quantity (shares, contracts). Tight stop = more quantity.

Using a fixed percentage formula solves the sizing question. Assuming your account is $10,000, your percentage risk per trade is 2%, your max loss is $200. Now divide that by the stop width and you have position size. Easy enough.

Here is a sample of some popular stop loss placement methods:

1. Multiplier of Average True Range (ATR) based on the chart time interval used for entry/exit. The rationale is if your stop is just beyond 1 ATR away then you likely won’t fill it more than half the time.
2. Prior candle low plus a few ticks. This also considers the current volatility. Entering when the prior candle is narrow suggests a bigger stop is not required. Entering when the prior candle is wide gives extra room for the current movement.
3. Beyond a moving average. The 20-period SMA or XMA are popular.
4. Fibonacci levels based on the prior pivot high/low.
5. Support/Resistance levels

There are many more methods. The question is which one to use? The only way to be confident in your choice is to examine hundreds, even thousands of prior trades. You need statistical relevance. Small sample is worthless.

Document historical trades based on several methods. Keep track of the Maximum Adverse Excursion (MAE, the distance the trade went against you but didn’t stop out). You’ll have a data set that will allow you to fine tune the stop placement.

Here’s an example from our Volume Profile strategy what your analysis can tell you. From a sample size of 9384 trades in all market conditions: Stops = 3283 or 35% of the time (average stop 3.50 points). MAE on the remaining trades averages 1.50 points. These metrics were the best using a stop of 3 ticks beyond the volume level.

The numbers for you will vary based on your strategy entry/exit rules. Do the homework and find stops you can be confident in.

 Trade Well,

Mike Siewruk

P.S. Join us every Saturday morning @ 10:00 ET for our weekly LookBack (5) trade review session. Every trade for the week is analyzed. Now open to the public. Meet the team. Ask questions. Register here.