When a stop level does get hit, it’s easy to think that its due to bad stop placement … if I’d just had it a bit wider … but the reality is that even the smartest stops will get hit. If your stops aren’t getting hit, then they’re probably too wide and not really doing their job.
That said, there are ways to make our stop placement smarter, so our stops are managing our risk but minimizing their chance of getting hit. It involves 3 crucial steps …
Each of these is vital in smart stop placement. Without these considerations, you’re massively reducing your chance of success.
The first thing to consider in our stop placement is to get a rough idea of what’s a sensible distance to place a stop.
If we’re trading an hourly chart, and expecting our trade to be open for a day or two, we wouldn’t use the same stop distance as if we were trading a 5-minute chart and looking to take profits in the next hour.
We should think about what kind of moves are likely to happen between now and when we hope to hit our profit target. Obviously, it would be nice if the price drove a straight line to our target, but that very rarely happens, and retracements are a very normal part of successful trades, so we should be prepared.
Volatility stops are really powerful – they naturally bring stops in tighter when volatility is low, and have wider stops when volatility is high. This allows us to take advantage of momentum when trends are picking up speed. But it also allows us to batten down the hatches in low-volatility periods, like during a consolidation range.
The most basic tool for adding a volatility indicator is the average true range …
The Average True Range indicator gives us average range of movements across previous candlesticks. The default setting is 14, so it’ll look at the average high-low over the last 14 bars and give us an average figure. It’s a good way to assess what kind of moves we can expect to see over the next few bars.
When used as a guide for stop levels, traders will usually take a multiple of this figure to set the stop loss a nice safe distance away. In the example below, the stop is set 3x the ATR above our entry price …
Once you’ve assessed an appropriate distance to position your stop at by considering volatility, the next step is to check whether this level needs tweaking because of support and resistance levels or round numbers.
The accepted wisdom around these key levels is that we want our stop loss level just beyond them, where price will turn before our stop gets hit. But it’s important to remember that levels of S&R are also magnets for price behaviour because so many people put their trade orders around them. That’s why we need to give these key levels some breathing room.
How much breathing room? Well, that’s the question.
Too tight, and we’re a target for stop hunting. Too wide and we’re taking more risk than we need to. There’s a degree of trial and error here, along with some acceptance that we’ll always be wrong some of the time!
So, you’ve decided a smart stop distance based on the volatility of your market … and you’ve adjusted it a little because you wanted to outside a recent level of resistance. Now it’s time to put your stop level to the final test …
Does the potential reward justify the risk you’re taking on this trade?
• Compare the distance to your stop and the distance to your target. What’s the reward-to-risk ratio? Is that within the parameters of what you’re happy taking?
• Have you moved your stop out so wide that this trade no longer looks like a good opportunity?
• Is the stop so tight (perhaps due to recent lack of volatility) that you’ll be using a much larger stake that you’d expect (this will impact your trading costs and margin requirements).
If any of these things are making your trade look a bit iffy … now is the moment to reject this setup. More opportunities will be along. DON’T be tempted to move your stop again at this point just to suit the kind of setup you’d ‘like’ this to be.
If the market isn’t offering you the setup you need for good placement of your stops and targets, then it’s not a good trade to be taking. Save your money for the best opportunities – that’s how you get a good success rate, along with a sound risk-reward ratio.
Next week I’ll show you some reliable tools for positioning volatility stops.
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