As traders we endeavor to catch a trend early and hold that position until an objective or target price is met. Catching a trend is difficult enough; squeezing the last dollar out of a trade is even harder. Stop loss orders are used to set risk. As another option they can also be used to manage profitable trades with an order type known as a “trailing a stop.”
Setting a Stop Loss
Once a position is taken, the next step is to set a stop loss price. When a stop loss order is triggered it becomes a market order, which means buy the offer or hit the bid. Sell stops are set below entry and buy stops are set above. Stops are mainly used as protection against unexpected reversals in direction. The trick is to select the correct stop loss price that is far enough away so as stay in a position versus closing it out with reasonable risk.
Risk varies for all traders. Account size and time frame are critical when defining risk. When taking a short-term bullish trade, I like to set my stop loss at a price that is 50% of an average day range below the entry level. If a short position is taken, I set a stop loss 0.5 ADR (average day range) above entry price. Choose a stop loss percentage that fits your risk profile.
Trail Stops to Lock in Profit
To ride trends, it’s a good practice to utilize a trailing stop as your trade becomes more profitable. When entering trades that are deemed to be swing trades or longer-term trades (3 to 5 days), I use a trailing stop technique. First you need to determine a daily and weekly ATR (average true range). A 14-day and 9-week ATR are the benchmarks I use to be current with volatility.
Assume we have a signal to buy a stock at $50, and the ADR (average day range) is $8 and the AWR (average week range) is $20.
Risk (Stop Loss) = 0.5 ADR ($4) minus entry ($46 = stop)
- The next step is to set profit targets. To do so refer to ADR and AWR.
- Target 1 (T1) equals 0.5 ADR above entry price on a long position.
- If target 1 price is reached ($54), then stop loss moves to entry ($50). At this point if the market reverses the trade will be a scratch. The goal is to reduce risk just in case the trend higher does not materialize.
- Target 2 (T2) = 1 ADR or $58 (entry + ADR). When this level is touched the stop jumps to T1 or $54. Now if the trend reverses a profit will still be realized. Trailing stops lock in profit.
- Target 3 (T3) = 0.75 of AWR (entry + $15 = $65). If T3 is attained stop moves to T2 or $58, thus locking in more profit.
- Target 4 (T4) = 1 AWR plus entry or $70 ($50 + $20). When T4 trades stop moves to T3 or just ring it up as a good winning trade.
Stop loss orders can switch to preserve profit. They are a great way to eliminate risk quickly and accelerate profit potential as the market moves to projected profit targets.
Senior Technical Analyst
Market Taker Mentoring, Inc.