Before ever entering a trade, you should already know how you are going to get out. The trade should be planned end-to-end, whether the plan turns out to be a winner or loser. In this post I’m going to discuss how to set stops to protect yourself from your biggest enemy, you.
Mental Stops
Mental stops are a questionable strategy. As a trader, the biggest battle you face is not against the market (you will lose that battle, I promise), it is the battle against your own mind. Any chance to eliminate your mind from the process of trading gives you an edge over someone who has to waste precious moments thinking.
Perhaps it’s just me, but I have found that when I use mental stops it allows for that moment of doubt that the trade is failing or hope that the trade will succeed. Those moments cost me and could add up to kill my account if I let them. So how do we protect us from ourselves? Stop loss orders.
Where to Place Stops
The 3 basic type of trades that I use when I’m day trading are breakouts, bounces & hopping into a trend. I place my stops for all of these trades based on the nearest support/resistance or the breakout or bounce level (also support or resistance).
Stops for Breakouts
Breakout stops should be placed just behind the breakout level. The idea behind the breakout is that there’s such a build-up of pressure at that level that the resulting volatility should easily push the price well beyond that level If the price hesitates and wanders back into pre-breakout levels, then this trading set-up has failed.
Give breakouts a few pennies of wiggle room, but if the trade doesn’t pan out almost immediately, you should be out of there and looking for your next opportunity.
Stops for Bounces
Bounces are higher risk than breakouts. This is because a failed bounce becomes a breakout and the price can quickly get away from you. Just like breakouts, stops on bounces should be kept tight.
The smallest break beyond the bounce level can trigger a breakout, you should give these trades little leeway by placing a stop 1 to 2 pennies behind the bounce level.
Stops for Trend Trades
Trend trades are generally lower risk, because you’re simply going with the flow. When I hop into a trend, I will place a stop beyond a nearby support or resistance level.
These levels can be recent highs or lows, levels of previous support/resistance (even going back a few days), or the prior day’s OHLC.
The trick with trend stops is assessing your risk:reward expectations. If you feel a stock is trending well and may carry on through the day, give it a little room to run. If you believe the stock could turn at any moment, tighten it up. It really boils down to how much risk you are comfortable with.
You should never enter a trade that hasn’t been planned for both outcomes, positive and negative. I feel that the most important part of this planning is what to do on failed trades. In a coming post, I will address exit strategies when you’re in the green.
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