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How To Place A Stop Loss & Profit Target Like A Professional (Part 1)

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by , 05-26-2014 at 11:28 PM (2548 Views)
Quote Originally Posted by matfx View Post
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Today’s article is going to give you guys a “sneak-peak” into exactly how I decide on my stop and profit target placements. I get a lot of emails asking how I decide where to place a stop or where to place a target, and while there is no one-size-fits all answer to this question, there are certain things that you should consider before entering a trade that will make determining the best stop and target placement much easier.

Placing stop losses

I am starting with stop loss placement for a couple of important reasons. One, you always should think about risk before reward and you should be at least two times more focused on risk per trade than you are on reward. Two, we need to determine our stop loss to then determine our position size on the trade, potential dollar loss and gain, and our R multiples. This will all become clearer as you read on if you were confused by that last sentence.

General stop loss placement theory:

When placing stops, we want to place our stop loss at a logical level, that means a level that will both tell us when our trade signal is no longer valid and that makes sense in the context of the surrounding market structure.

I like to always start with the premise that I will ‘let the market take me out’, meaning, I want the market to show me that my trade is invalid by moving to a level that nullifies the setup or changes the near-term market bias. I always look at manually closing a trade as option number 2, my first option is always to ‘set and forget’ the trade and let the market do the ‘dirty work’ without my interference. The only time I manually exit a trade before my predetermined stop gets hit is if the market shows me some convincing price action against my position. This would be a logic-based reason to manually exit a trade, rather than an emotion-based reason that most traders use to exit on.

So to recap, there are basically two logic-based methods for exiting a trade:

1) Let the market hit your predetermined stop loss which you placed as you entered the trade.

2) Exit manually because the price action has formed a signal against your position.

Exits that are emotion-based:

1) Margin call because you didn’t use a stop and the market moved so far against your position that your broker automatically closed your trade.

2) Manually closing a trade because you ‘think’ the market is going to hit your stop loss. You feel emotional because the market is moving against your position. But, there is no price action based reason to manually exit.

The purpose of a stop loss is to help you stay in a trade until the trade setup and original near-term directional bias are no longer valid. The goal of a professional trader when placing their stop loss, is to place their stop at a level that both gives the trade room to move in their favor or room to ‘breathe’, but not unnecessarily so. Basically, when you are determining the best place to put your stop loss you want to think about the closest logical level that the market would have to hit to prove your trade signal wrong. So, we don’t want to put our stop loss unnecessarily far away, but we don’t want it to close to our entry point either. We want to give the market room to breathe but also keep our stop close enough so that we get taken out of the trade as soon as possible if the market doesn’t agree with our analysis. So, you can see there is a ‘fine line’ that we need to walk when determining stop placement, and indeed I consider stop placement one of the most important aspects of placing a trade and I give each stop loss placement a lot of time and thought before I pull the trigger.

Many traders cut themselves short by placing their stop loss too close to their entry point solely because they want to trade a bigger position size. This is what I call “trading account suicide” my friends. When you place your stop too close because you want to trade a bigger position size, you are basically nullifying your trading edge, because you need to place your stop loss based on your trading signal and the surrounding market conditions, not on how much money you want to make.

If you remember only one thing from today’s lesion, let it be this: always determine your stop loss placement before determining your position size, your stop loss placement should be determined by logic, not by greed. What that means, is that you shouldn’t purposely put a small stop loss on a trade just because you want to trade a big position size. May traders do this and it is basically like setting yourself up for a loss before the trade even starts.

Examples of placing a stop loss based on logic:

Now, let’s go through some examples of the most logical stop loss placements for some of my price action trading strategies. These stop placements are what I consider to be the ‘safest’ for the setups being discussed, that means they gave the trade the best chance of working out and that the market must move to a logical level against your position before stopping you out. Let’s take a look:

Pin bar trading strategy stop placement:

The most logical and safest place to put your stop loss on a pin bar setup is just beyond the high or low of the pin bar tail. So, in a downtrend like we see below, the stop loss would be just above the tail of the pin bar, when I say “just above” that can mean about 1 to 10 pips above the high of the pin bar tail. There are other pin bar stop loss placements discussed in my price action trading course but they are more advanced, the stop loss placement below is considered the ‘classic’ stop loss placement for a pin bar setup.

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Inside bar trading strategy stop placement:

The most logical and safest place to put your stop loss on an inside bar trade setup is just beyond the mother bar high or low.

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Counter-trend price action trade setup stop placement:

For a counter-trend trade setup, we want to place our stop just beyond the high or low made by the setup that signals a potential trend change. Look at the image below, we can see a downtrend was in place when we got a large bullish pin bar reversal signal. Naturally, we would want to place our stop loss just below the tail of that pin bar to make the market show us that we were wrong about a bottom being in place. This is the safest and most logical stop placement for this type of ‘bottom picking’ price action trade setup. For an uptrend reversal the stop would be placed just beyond the high of the counter-trend signal.

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Trading range stop placement:

We often see high-probability price action setups forming at the boundary of a trading range. In situations like these, we always want to place our stop loss just above the trading range boundary or the high or low of the setup being traded…whichever is further out. For example, if we had a pin bar setup at the top of a trading range that was just slightly under the trading range resistance we would want to place our stop a little higher, just outside the resistance of the trading range, rather than just above the pin bar high. In the chart below, we didn’t have this issue; we had a nice large bearish pin bar protruding from the trading range resistance, so the best placement for the stop loss on that setup is obviously just above the pin bar high.

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Stop placement in a trending market:

When a trending market pulls back or retraces to a level within the trend, we usually have two options. One is that we can place the stop loss just above the high or low of the pattern, as we have seen, or we can use the level and place our stop just beyond the level. We can see an example of this in the chart below with the fakey trading strategy protruding up past the resistance level in the downtrend. The most logical places for the stop would be just above the false-break high or just above the resistance level.

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Trending market breakout play stop placement:

Often, in a trending market, we will see the market pause and consolidate in a sideways manner after the trend makes a strong move. These consolidation periods typically give rise to large breakouts in the direction of the trend, and these breakout trades can be very lucrative sometimes. There are basically two options for stop placement on a breakout trade with the trend. As we can see in the chart below, you can place your stop loss near the 50% level of the consolidation range or on the other side of the price action setup; in the example below it was a pin bar. The logic behind placing your stop loss near the 50% level of the consolidation range is that if the market comes all the way back down to that point the breakout is probably not very strong and likely to fail. This stop placement gives you a tighter stop distance which increases the potential risk reward on the trade.

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Note on placing stops:

So, let’s say we have a price action trading strategy that’s very close to key level in the market. Ordinarily, the ideal stop placement for the price action setup is just above the high of the setup’s tail or the low of the setup’s tail, as we discussed above. However, since the price action setup tail high or low is very close to a key level in the market, logic would dictate that we make our stop loss a little bit larger and place it just beyond that key level, rather than at the high or low of the setup’s tail. This way, we make the market violate that key level before stopping us out, thus showing us that market sentiment has changed and that we should perhaps be looking for trades in the other direction. This is how you place your stops according to the market structure and logic, rather than from emotions like greed or fear.

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