Monday, November 3, 2014

STOP-LOSSES, ENTRIES, AND EXITS

A REVIEW OF STOP-LOSSES, ENTRIES, AND EXITS
FOR THE PRICE ACTION TRADER

First of all, every trader should be using a stop loss.  When placed properly, they are there to protect you in cases when the market has unpredictable volatility or when price moves against you (despite having given you all the “right” signs).  Some traders believe that the big movers and shakers of the market are “stop-hunting” and purposely pushing the market one way or another to take out the retail traders stop-loss positions; I don’t believe that to be the case at all.  If you are finding that your stop-losses are regularly getting hit, the most likely problem is that you aren’t placing them in the correct location and/or you aren’t entering the market at the right place. 


Let’s look at an example of a current bearish trending market, gold.  The chart that I primarily trade off of is the New York close daily chart, so that is what we are focusing on here.  I use the weekly chart to guide my support and resistance placement, and use 10 and 20 day EMAs for dynamic support and resistance. We are going to be looking for two of the most common price action signals, the rejection candle and the inside day combo.  


TRADE ONE printed a bearish rejection candle (with a bullish close).  If you could see the chart to the left, you would see a nice bearish trend in progress; therefore, this rejection candle off of the 10-day EMA is a continuation signal (meaning that the market is likely to continue in a bearish direction).  If you decided to take this signal and place a short order, the stop loss should be place a little above the high of that rejection candle.  This particular candle is somewhat large, which makes our risk a little higher.  It is always ideal if we can enter the short trade at a 50% retracement for better entry position and smaller risk carried.  Luckily, the next day’s candle seems to have just hit the 50% retracement mark before dropping in price (and if it didn’t, the third day after the rejection candle definitely did – however, at this point the market is moving sideways and the trader may have decided not to open the trade).   Trade one, if taken, would have reached over 3X risk payout. 

That brings us to TRADE TWO.  Personally, I would not have taken this trade because although the market was very gradually stepping down, the price action seemed too sideways and unpredictable to me.  You shouldn’t trade in sideways markets.  Also, because we are in mid-range between these two support levels, I am not likely to be able to get my desired 3X risk/reward ratio unless price were to break through the support level (as we can see, price stopped at the lower support level and gave a little over 1X risk, not enough to tempt me).  What we have here is an inside day combo.  Normally, in a trend, inside day candles printed on the daily chart can be the precursor to very strong moves (and indeed there was a strong move two days later).  If a trader were to have taken this trade, they should have set their stop loss just above the high of the inside day candle (or if they were really conservative, above the high of the mother candle) – and their entry at the break of the low of the inside day candle.  In this case the break out did not occur the day following the inside day candle, but on the following one. 

Now that price has reached the bottom of this support level, we see a strong rejection in the form of a bullish power candle.  I am not going to trade the retrace, so for this example, I am only looking for sell signals.  At this point, we should be waiting for price to retrace up and test the resistance level above. Sometimes price will not go all the way up to test the resistance but will come up a little and then plummet down again to test support or break through it.  But in this case we see a straight bullish climb up to the opportunity of TRADE THREE.  This one is tricky.  It looks like a good bearish rejection signal, but see the candle just prior to trade three’s candle?  It has broken upward through both the ten-day and twenty-day EMAs.  All of the candles pictured before it were respecting the 10-day EMA and it was acting as dynamic resistance.  Now that this candle has broken through these EMAs, we see that the candle for trade three is sitting on-top of the EMAs and they are now acting as support.  So, despite that fact that we are seeing a bearish signal, we should be wary because price may ride that upward pressure to the next level of resistance – and that is just what happened.  If we had entered trade opportunity #3, our stop loss would have been taken out. 

TRADE FOUR is another inside day combo, with a high that almost touches our level of resistance before dropping back down.  This signal is not valid in my opinion though, because the mother candle is so large, that it isn’t surprising that the next candle falls inside of it.  Usually, an inside day candle combo (that falls within a trend) means that price is consolidating and about to break out; in this situation however, we just have a volatile mother candle followed by a couple indecision candles.  Again, I wouldn’t have considered this a valid setup.  The only thing that this candle told me is that the level of resistance above is holding so far. 

The next trade opportunity, TRADE FIVE, was a nice little rejection candle or pin bar.  It pierced the s/r level and then price was pushed back down just as we would like to see it.  Unfortunately, the next day’s candle did not retrace to the 50% mark, so the trader would have had to make a decision of whether to enter the trade at a lower price (more aggressive move and a bigger risk); none-the-less, if he had done so – in this instance, it would have paid off. 

If a trader missed that boat, another opportunity presented itself in TRADE SIX.  I actually did take this trade, and with entry at the 50% retracement point my profit exceeded 10X risk/reward when I finally exited the trade.  Initially my take profit target was the bottom s/r level, however when I saw how strong the moves were leading up to the approach of my target, I decided to move my target down and trail my stop-loss conservatively behind the price movement.  This enabled me to remove my risk and lock in some profits, while trying to maximize my return on the bearish move.    


WRAPPING UP

In this illustration of the gold bearish trend selling opportunities, we see that trade’s one, five, and six were our best opportunities.  That is what trading is really all about, being able to minimize our risks and maximize the potential of our trade decisions.  The placement of stop-losses, entry positions, and exit positions are all dependent on what type of signal you are taking, the size of the signal, and where the signal is located relative to the support and resistance levels (horizontal or dynamic) of the chart. 

The two signals that we identified today are most reliable in the conditions shown above on the daily chart.  The lower time frame charts may give the same signals, but they are not as safe to trade.  Remember, it is always safest to trade with the trend, especially for the beginner trader.  But to trade with the trend, you have to be able to identify one!  If you can’t tell what a chart is doing, either because the price action isn’t clear to you, or just due to your inexperience, you shouldn’t be taking a trade.  

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