Don't Stop Me Now!
One of the most common questions I have asked of me is where a trader should place their stops for maximum effectiveness and still not be stopped out too soon by normal market fluctuations. A specific question posed to me was:
Q: My biggest problem is that I do not know where to set up my stop losses without being taking out too early or too late. Is it true that Market Maker can see all of the stop losses in their computer and move the price around that to benefit them?
A: To answer the second part of your question, yes and no. The market makers can only see stops that are placed on their own system from their clients. So ScottTrade's market makers know where all of ScottTrade's clients are placing their orders. This is one reason why Online Trading Academy teaches trading through Direct Access brokerages. If you place a stop order on a direct access trading platform, the order is usually held in the brokerage's server and is not seen by the market or the other market makers until it is activated. You must know your broker's stop policies, however. There is a different type of stop order routing that is used by some direct access brokerages. This stop order is routed to an ECN and held at the ECN server until activated. This type of order may be seen by all who subscribe to that particular ECN. The ECN AUTO is one such ECN that will house orders.
Remember that market makers are smart. They do know that most people will place stops around whole, decade, or century numbers and will "run" the stops to shake you out. You should also place stops NEAR support and resistance, not AT support and resistance for the same reason.
Setting proper stops can be tricky. You should always maintain the 3:1 Reward to Risk ratio or do not take the trade. Identify your entry point, your exit point, and calculate your potential profit for the trade. Divide that number by three and that should be your maximum stop loss. You can also refer to the Average True Range to see if your stop is too tight for the time frame you are trading.
For example, the potential trade in the chart below shows a possible short with a profit of $0.33 (Short entry at about $53.75 and exit near $53.42).
However, the ATR for every five minutes is $0.23. We could take the short with a stop of about $0.10 but we run the risk of getting stopped out with normal stock vibration. It would be better to move on and find a higher probability trade.
For swing trades, I use similar criteria. A trade with a $3.00 potential profit and a $1.00 stop may get stopped out too early if the ATR is $1.75, but may be ok if the ATR is $1.25 or less. I also look at doubling the ATR and using the smaller of the ATR x 2 or 1/3 of my potential profit.
Another type of stop is the Chandelier exit which is featured in (November's) Technical Analysis of Stocks and Commodities magazine (www.traders.com). It involves multiplying the ATR by three and subtracting that number from the most recent high (or low if you are short). Just remember to maintain proper risk vs reward ratios (3:1). This type of stop works best in trending markets.
Here we see NVDA breaking out from a recent high in an uptrend. We could go long the day after the close above the high of $36. Let's suppose our entry was $36.15. The ATR on that day was $1.03. We multiply that by two (or three if your risk tolerance is higher) and "hang" that from the recent high of $36. $36 - $2.06 = $33.94, our Stop.
Changing the stop can prove challenging as well. Once you can breakeven, you may choose to move your stop high enough to cover exit with no loss, even covering commissions! If another swing high presents itself, I usually move up my stop to protect any profit.
Here we have a pullback from a new high of $43.87. A check of the ATR at that time shows $0.98 Daily ATR. We multiply that by two and hang it from the high. This gives us a stop of $41.91 which is taken out for a $5.76 gain. We can re-enter a new trade when we clear the high of $43.87 and repeat the process. Doing this would have created more profitable trades in the trend.
These stop guidelines would work on any type of security. We can use them in trading currency, futures, commodities, and of course stocks. I hope this answers most of your questions about stops. Look out New York, UK and Singapore; I'm on my way! I'll be teaching in two of my favorite locations next week: The Broad Market Analysis class in NY this weekend and then across the pond to see the Brits! Next month I visit one of our newest locations, Singapore! (They don't cane you for making bad market predictions do they?) Online Trading Academy is growing and I'll be seeing many of you at the new locations popping up everywhere! Until then, may all of your trades be green and your losses small!
Until next time, happy trading!
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As a former stockbroker, brokerage trader, and hedge fund trader, Brandon brings various market views and insight to his classes. A wealth of knowledge, he has held NASD securities series 7 and 63 licenses. An Online Trading Academy graduate himself in 1998, Brandon has been trading his own account since. Brandon taught for Online Trading Academy in 1999 to 2001 before becoming a Realtor and Mortgage broker holding licenses in 15 states. Returning to the Online Trading Academy family late 2005, he now balances trading, teaching and a real estate career.