Stops -- The hows, whys, whats, whens and wheres  

Trading 101 says "ALWAYS place a stop". So you follow that rule and three trades later you have been stopped out on every position losing a total of 30 pips.

Well, silly trader. Your stops were too tight. I can guarantee that a 10 pip stop will be hit in close to 100% of your trades. So what is the right level?

A simple answer is: A stop should be 10-20 pips beyond the level that determined why you entered the trade. For example, if you entered a long trade because price exceeded yesterday's high, then set your stop at 10-20 pips below yesterdays high.

There is a problem with the whipsaw effect though. To illustrate lets take a look at the following GBP/USD hourly chart. I want to take the short trade at the closing price of 1.4878. There are a host of good reasons for this trade but the primary trigger is that price closed below the 62 EMA (Blue colored line). I want a target of 100 pips and I would place a stop at 1.4935 which is 23 pips beyond my trigger, the 62 EMA. This follows the simple stop rule. [side note: This setup is for illustration purposes only. Don't use a similar setup for an actual trade. Play along with me though and you will see the point!]

The next chart shows the whipsaw that stops the trade out. At that first stop it is easy to believe that the previous uptrend is going to be continued. This would mean that price would continue to rise after hitting the stop.But in fact, price returns downward with a candle closing again below the 62 EMA. So I enter a short trade again at 1.4894. I set the stop at 1.4935 (same as last time) and my target is now 116 pips.

Oops! I get stopped again. Two trades, two stops, and I am down 96 pips. I must be an idiot to have believed that price was going down. Obviously price is going to return to the uptrend as it won't break through some support level around 1.4865. So I should reverse and ride the trend up and up!

That would be a silly move as the next chart shows. Price in fact makes my initial target and with 20 or so pips beyond before encountering any support. So where was the error? Did I just enter too soon? Were my stops too close? And if that's the case how big should my stops be?

The answer is that the stop was at the wrong level. The right level is illustrated in the third chart. It is above the Pivot point. The Pivot point (shown as a dashed magenta line) works as a protective barrier far better than the 62 EMA. But if you regard the 62 EMA as the first barrier, then the stop is placed two barriers beyond entry price. Under this scenario, the first trade could be held to completion. If a 83 pip stop is too steep, then entering the trade at either circled point would yield a more modest stop and a very profitable target.

The new stop rule: Set your stop 10-20 pips behind a protective barrier a level deeper than your entry trigger.

The next question that should jump out is "What are protective barriers?" Any price level that acts as support or resistance is a protective barrier. I don't want to over use the term "barrier" but it is an illustrative term. But to get back to standard terminology, we are talking about support and resistance. The support and resistance levels (SR levels) I use are the 62 EMA, the 248 EMA, the 800 MA, the Pivot points (Pivot, S1, S2, R1, R2), Fibonacci levels from the most recent trend of at least one day, and the previous day's high or low. For stops and targets, the ones I use the most and in order of significance are Pivot Points, 62 EMA, and Fibonacci levels. Any time two or more SR levels are close together or equivalent, I regard that level to be especially strong.

There is much more to be said about stops, but we will have Part 2 in a later post.