Using Stops Effectively
Learn to Trade Better

Choosing proper stop levels after placing an entry order is almost the most critical part of protecting open trades. If they are too tight, trades will possibly be stopped out frequently with losses. If they are too wide, they may not be as effective in protecting against unwanted losses. Where in the heck do we place our protective stops so that they are perfect? This is the question In intend to try to solve for you.

The way I try to look at this problem may be a bit different than other people. I look at it as we have to adjust stop strategies according to the timing of the trade (beginning, middle or near the end), to the conditions of the market (strong or weak), and to the potential outcome of our actions.

Keeping this in mind, I’m sure you have quickly realized this section will go into many different issues – and you’re probably right. The main thing to remember here is “what are we trying to accomplish with the stop?” and thus “where should it be placed?”.

Entry Order Protective Stops

Entry order stops are designed to be our first defense against excessive draw downs and losses. They should be considered as part of our “What If I’m Wrong” strategy – basically as a floodgate preventive measure to protect equity. So, where do we place our initial entry order protective stops? We must consider the most recent market price action and use current support resistance levels to try to determine the most logical stop price level as well as the most appropriate level to try to let our trade mature into profits.

When placing stop orders, we really need to consider what we expect the market to do in the future and how much we are willing to risk. Of course, if we could risk nothing, that would be the ideal solution to this problem. There are some instances where we can risk almost nothing, but in most cases, some level of risk is inherent in every trade.

Entry Stop Level Example #1:

In this example, we explore the use of support, resistance and conservative market expectations. Let me explain all the lines and stuff on this chart to help illustrate the example…

The lines near the upper portion of this chart reflect resistance. The resistance levels I chose were based on the downward sloping trend channel (originating from the previous bearish trend) and the double Doji formation. Often, the body’s of Dojis are actual support or resistance. Most people don’t know this – so you might want to remember this.

The other lines on the chart are support. Of course, the low of the chart is our most substantial support level. But there are other support levels on this chart too. The shaded area created by the two Dojis, just before the bottom, indicate a “support range”. With a support range, we are essentially identifying a narrow price range that should act as a secondary support level. In this case, the low of the candle that issued the BUY SIGNAL helps to confirm our support range.

What we should realize when the BUY SIGNAL is issued with this chart is the following….

1. The current downward sloping resistance channel is still in tact and will present a potential for a retracement if the market continues upward to reach this level.
2. Knowing the potential for a retracement and the potential price level where it might occur, we can estimate potential $4.00~4.50 profit target range (initially).
3. We also know that support exists near $30.00 (the most recent low) and the $31.50~32.50 level.

This means that if we are lucky, our LONG MARKET ORDER will be filled near the close of the candle that issued the buy signal (or about $33.50). If we get really lucky, the open of the following session will be a bit lower.

So, realistically, we should place our stop at or below $30.00 – right? Probably not. It is acceptable to place a stop near the $30 level simply because it is our most concrete support level, but because we are only expecting a $4~$5 profit target, a stop that is $3+ away from our entry would reduce our risk/reward ratio to less than 2:1.

The most appropriate stop level for our entry order is the support range created by the Dojis (or $31.50). I understand that this stop price adjustment only increases our risk/reward ratio to about 2.5:1, but realistically, this support level has to hold over the next few trading sessions for the market to attempt higher price levels.

So, we would place a GTC SELL STOP ORDER at $31.50 to protect our trade. Once the market price accelerated away from our entry price, we would consider adjusting our stop price accordingly. We’ll learn more about this technique in the “Mid-Trade Protective Stops Adjustments” section of this book.

Entry Stop Level Example #2:

In this example, we explore the need to immediately modify our entry stop price level because of a price gap. This is an important factor of trading because gaps normally act as support or resistance as long as the gaps are not broken with price action.

The candle that generated the BUY SIGNAL also presented a new, potentially substantial, trend channel. It is important that we identify this new trend channel as it plays into our expectations of future price activity. The line with the double-arrows indicates the two valleys where we identified the price channel.

When the buy signal formed and we placed our entry order, our only support level (or stop level for our entry trade) was the support trend channel. So, we would have initially placed our GTC SELL STOP ORDER at $33.25 (or just below the current lows).

The following day, the market GAPS up sharply and we get filled on our entry order above $37.00 (now nearly $4 away from our stop). The price gap created additional risk in our trade that we should immediately attempt to reduce or remove.

The most appropriate strategy in this type of situation is to move our stop below the low of the price gap (in the case of a Long Trade and a Bullish Price Gap). So, we would immediately most our stop to the lowest level of the price gap as soon after we are filled as possible and wait to see what happens. The gap will act as support for the market and we should be watching for any breach of the upward sloping trend channel as a sign that the market MAY REVERSE.

In the event of a bearish price gap after a sell signal, we would do the exact same thing except we would move our stop to the high of the bearish gap range.

Entry Stop Level Example #3:

In this example, we explore the need to immediately modify our entry stop price level because of a large range entry bar. Sometimes, a candlestick bar will be much larger than a normal bar. This is normally a good sign for the future trend, but can distort our risk/reward ratio simply due to the increase in volatility. It is often necessary to adjust our entry stop price level immediately after our entry order is filled simply to reduce the amount of risk.

In this example, we first notice the support level near $39 and the previous top near $42.25. Even though this is not a huge range, it is a decent range to trade (about $4).

As you can see, the candlestick that issued the buy signal is LARGE and closes at almost $40.50 (only $2 away from our profit target). Where do we place our stop on this trade?

This is where we begin discussing the “Waist Line” of the candle, or the exact midpoint of the high~low range (shown here by the short Magenta line). The waist line should be used for large range candles as a support/resistance level – especially if we are attempting to protect a position.

Initially, our stop price level should be near $39 because of the support that goes back to the base near the left edge of the chart. When our order gets filled at $40.38 and we realize we were not filled anywhere close to our stop (or within the body of the previous candle), we soon realize we need to make some adjustments to our opening stop level.
As soon as our market order gets filled, we need to adjust our entry stop price to the “Waist Line” of the large white candle (or near $39.68) to help reduce our risk in the trade.

We’ll get another attempt to use another “Waist Line” only two days after our entry trade. Another large range white candle forms in our bullish trend and this time we would adjust our stop level to $41.50 in an attempt to secure some profits and take advantage of the natural support level that is the “Waist Line” of large range candles.

Closing Comments On Entry Stop Levels:

There are many ways to develop entry stop level strategies, yet I find the traditional support/resistance and recent price action methods are still the best. I’ve had many people tell me about “parabolic curves” and “Dochanian Channels” (which might be fine for your trading style), but have yet to find something that beats the price chart.

I think it all boils down to “our ability to understand the charts” and the Japanese saying “if you want to know where the market is going, ask the market”. In other words, you can get almost everything you need right from the price chart. You should never move an entry stop level lower – unless you WANT more risk or find an error in your initial stop evaluation.

Mid-Trade Protective Stops Adjustments

Mid-trade protective stop adjustments are price level adjustments to an active stop order that are designed to accomplish any of the following benefits…

1. Move a stop level to “break-even” or “into profits”
2. Move a stop level to protect profits
3. Move a stop level to protect against potential weakness in the market
4. Move a stop level because of a previous error in establishing a protective stop.

Items #1 through #3 are designed to help you increase or maintain profits in your trade. Item #4 can be a benefit or a more disastrous move – depending on the reasons and actions taken.

The easiest way to understand when and where to move a mid-trade protective stop is to understand a few basic principles of market price action. Are you ready???

Price Acceleration - Most market trends react in “bursts” of trends, with congestion periods following bursts. These accelerations in market price should be watched for and used to you benefit. Normally, these bursts occur as the market attempts to move away from support or resistance. We’ll learn more about how to use these price bursts in a few more paragraphs.

Market Breathe - Market Breathe is the markets “natural rhythm”. Most price trends don’t go straight up or down – some do though. Most trends move up or down in a “wavy” type of price motion. This is essentially market breathe – or the natural ability of any market price to move within a trend, yet still oscillate up and down (like “micro-trends”).

Support/Resistance/Trend Channels - I know you’ve all heard it before, but no matter what anyone tells you, support, resistance and trend channels are derived from market price – so they are essentially a price pattern and are critical to our understanding of the markets. I have taught a few tricks and a few common techniques in using these “facts of price” and we’ll continue to learn more.

Market Intuition - Intuition – how do you teach intuition? Well, you’re already learning it – you probably just don’t realize it. Every little hint I can offer you and every example in this book are designed to help guide you through a trading decision. I can’t give you intuition, but I can help you refine and explore your ability to become more intuitive regarding market price.

Lets go over some simple guidelines for adjusting stop price levels before we get into the examples. This way we can try to consider the necessary process for adjusting stop levels effectively.

After you place your entry stop price level, the only reasons why you would want to immediately adjust this existing level are as follows….

1. Your order is filled much higher or lower than you expected and there is now additional risk in the trade (the filled price is too far from your stop price).
2. The market gaps up or down on the bar you were filled. The gap represents support or resistance. Move your stop to the low of bullish gaps or the high of bearish gaps to protect your trade.
3. Your order gets filled near the expected price, but continues to rally extensively or sell off excessively. This means that your trade was correct and you are already seeing profits. But it also means that your stop price level may include too much risk. This is where you would either use the Waist Line of a candle or the most recent lows as your next stop level.

NEVER RE-ADJUST YOUR ENTRY STOP PRICE TO INCLUDE GREATER RISK unless you are completely sure of what you are doing. The only reason I could think of where you would want to do this is if you made a serious mistake placing your original stop.

After placing the initial entry stop price level, we should be expecting the market to move away from this level and begin to show profits. There should be no reason to modify this level unless we really screwed up. Now, the only reasons we would choose to modify the stop price level is as follows…

1. The market has accelerated away from our entry price and we want to trail our stop to protect our interest in this trade.
2. The market has congested after our entry trade and we want to move our stop to a new support or resistance level – thus effectively reducing the risk within our trade.
3. The market price has moved up excessively and we want to attempt to trail our stop to lock in some profits. Another attempt to lock in profits would be to liquidate a portion of our portfolio and trail our stop to a new level.

This about covers the necessary processes of adjusting stops. Remember, traders use stops to protect and to limit losses, as well as to try to lock in gains. A stop level that is too tight will most likely get hit and stopped out (with a small loss). As you become more aware of the Principles of Market Price Action, your skill at placing stops and trailing stops will become more effective.

Let’s move onto some examples… We’ll use the same examples we used for the Entry Stop Price Levels – OK?

Mid-Trade Stop Price Adjustment Example #1

This example uses the same entry as the Entry Stop Example #1 & #2 – it just carries the analysis a bit further. In this example, I have labeled all of the points of interest with A through I. We’ll go through them in order to illustrate my points.

I thought I should mention that an alternate mid-trade stop adjustment strategy would be to simply adjust your stop to just below the support channel (shown below). Of course, we would not know the support channel actually exists until after “D”, but this type of stop trailing method is very acceptable under these circumstances.

A. As shown in a previous example, our initial entry stop level would be near this point (or somewhere within the support range). At this point, we are simply waiting for the market to begin accelerating upward before we attempt to tighten our stop.

B. This bar is an acceleration bar (with a high close, higher high and higher low). Another good example of an acceleration bar is “any bar with a higher close and where the body is greater than half of the total candle range”. At this point, we would move our stop to just below the current low (which would bring us to nearly “break-even”).

C. This bar is another acceleration bar. We don’t know the retracement is coming, so we can’t forward optimize our decision-making. All we can do is move our stop to just below the low of the most recent bar – which locks in some profits and protects against a POTENTIAL pullback. Within to more trading days, we get stopped out, but we have trailed our stops accordingly and have used the market price action to dictate where to place our stops. Our profit was about $1.40 per share.

Now, our stop has been breached and we have completed our first trade. At this point we would be watching the chart to see what happens.

D. At this point, we see a new BUY signal and would establish a new trend channel (using the past bottom and the recent potential base). We would place a new entry stop at a level equal to, or just below, the support channel to protect our trade

E. Our order (at “D”) gets filled much higher than we expected because of a price gap. We would immediately move our stop price to just below the price gap – where support is likely to be found. Next, we wait to see if the market accelerates again and stays above our new trend channel.
F. This candle is an acceleration bar even though it was not able to close at a higher price level than the previous candles. The size of the candle body was the clue here. It is very large compared to the total candle range. Thus, we would attempt to move our stop a bit higher (near recent lows) – which would move our stop price to near break-even.

G. After about 4 days of congestion, we see another acceleration bar with a higher close. The congestion that preceded this is a sign of weakness, so we would want to move our stop to the most recent low (or even the Waist Line of the current candle) in an attempt to protect profits. This type of move really qualifies as an “Exit Trade Protective Stop” – but we’ll discuss more of that later…

The very next bar our trade is stopped out (with about $1.80 profit) and we are seeing acceleration in the bearish direction. We should now expect a retest of the support channel. If the market price reaches the support channel and holds, then we would look to get back in with another LONG trade.

H. Another trend channel retest and a new acceleration bar to the upside. We get in again with an entry stop order at (or just below) the trend channel. Again, because of the size of the acceleration bar and the fact that we got filled a bit higher (far away from our stop), we could have move our initial entry stop to the Waist Line of the large range bar (at “H”). Either way, we are now waiting for another acceleration bar.

I. Another new acceleration bar. We need to move our stop again It is time to move our stop into profits (at or just below the current low) and wait to see what happens.

I know some of you are asking, why does this not work the same way when I’m really trading? Well, it can, but you have to remember that stops are to be used to protect positions and should be adjusted below the most recent acceleration level.

You might find that in the past, you were adjusting your stops arbitrarily and thus your stops may not have been as effective. You should also notice that I did not attempt to go short (or sell into) this market – why? It is simple, we had established a support trend channel and until that channel is broken (substantially), the market price should continue to go up. Why in the world would I want to short a stock that should continue to go up in the future??

The opposite side of the statement (above) will be answered in the Options Strategy section of this book. There are reasons to trade a “Put Option” (betting the market will move lower), but there are conditions and defined profit targets that come into play. We’ll get into this more in the Options section, but I just wanted everyone to know that there are ways to trade the retracements of a bullish trending chart by trading “Put Options”

Mid-Trade Stop Price Adjustment Example #2

This example uses the same entry as the Entry Stop Example #3. Now we’ll carry it forward.

A. As you probably remember, we entered a LONG trade with a BUY SIGNAL at “A”. We initially placed our stop at the support (just below $39.00). Because of the large range candle, as well as the order fill location, presented greater risk in the trade, so we moved the stop to the Waist Line of the white candle (“A”). The Waist Line is the exact midpoint of the total candle range.

After entering our trade and immediately modifying our stop level, we would simply wait for the market to move and attempt to reach the $42.50 resistance level.

B. The day after we were filled, the market again accelerated upward to nearly reach our profit target – but not quite. Another larger range (acceleration) bar, another attempt to use the Waist Line as a stop price level. Because of the quick acceleration of this price trend, I would caution that we should have expected the market to retrace almost immediately after this second large range bar. But it held in there for a while and actually managed to get above $42.50 (our profit target).

The third acceleration bar (right at the top) may have caused us to move our stop again (to about $42.70), but for this exercise, I think you get the idea. On large range acceleration bars, look first at the recent lows for support (and a potential stop price level), then look to the Waist Line as an alternate stop level. Ideally, we want to see enough market movement to warrant using the Waist Line. Use your best judgment.

Closing Comments On Mid-Trade Stop Adjustments:

Modifying a stop price level in the midst of a trade can be a nerve-wracking event. As traders become more experienced with these techniques, they will be better able to adapt to the different conditions of the markets. New traders, or those needing more experience, should use the time-tested techniques of support/resistance, trend channels and acceleration to their advantage.

Exit Trade Protective Stops

Exit stops are used to protect open positions and to set a level at which you wish to either exit out of a trade, or exit out of a trade and reverse your trade position (net-reverse).

Protection of your equity in any trade is critical for the long-term success of the trader. We’ve all heard stories of traders getting caught on the wrong side of a trade and not getting out in time, or of a trader leaving an open position on then going on vacation only to return to a margin call. Specifically for these reasons it is of critical importance that all traders actively monitor their open trades and actively use protective and exit stops. Think of stops as “Insurance” – just in case something happens.

Exit stops fall into three categories (in my book at least):

1. Simple Exit Stops
2. Scaled Exit Stops
3. Net-Reverse Exit Stops

Depending on your exit strategy and the market itself, you may choose to use just one of these strategies, or mix them up a bit. For example, you might choose to use a “Scaled Exit Stop” and a “Net-Reverse Exit Stop” to scale out of a trade at X price (say sell 1000 of your 2000 shares), then use the net-reverse ay Y price to net reverse at a certain price.

The concept of using exit stops is simple, these strategies are used in preparation of exiting a trade. The normal exit strategy is simply to SELL or COVER a previous BUY or SHORT trade. If the trader wanted to enter this order as a GTC Exit Stop Order, then it would be entered as follows…

I want to place a GTC STOP LIMIT ORDER to SELL xxxx of shares @ $xxx.xxx.

In this case, the trader is protecting the open BUY trade with a GTC SELL LIMIT order at (or below) a specific price. This is the ideal method of protecting the equity in any trade. Identify an Exit Stop Level, then place your GTC Stop Limit order.

Lets look at an example of how to effectively place and use Exit Stop strategies.

Exit Strategy Example #1 - Simple Exit Stop

A simple exit stop strategy consists of nothing more than identifying a protective stop level and entering your stop order to SELL or COVER the entire trade (all shares or contracts). Normally, this type of stop order is placed when the trader senses some potential weakness in the market or when the accumulated profits in the trade are substantial enough to warrant placing an order to protect these dollars. In any event, traders should use support or resistance levels, as well as trend channels and the specialized candlestick levels (neck line and waist line) to help identify protective stop levels.

For this example, we will use only one chart, a Daily Costco chart. We will discuss the decisions involved in making and placing an exit protective stop as well as where and why we choose certain price levels. Here we go….

In this example, we assume the trader entered a LONG trade off of the Piercing Line Confirmation pattern that formed where the upward sloping trend line begins and stayed long through most of the trend. Now, about 3 weeks later, the market is beginning to show signs of potential weakness and we have accumulated nearly $7.00 profit in the trade. Assuming we want to protect our equity in the trade, we should place an Exit Stop Strategy in place. Our simple exit stop strategy would consist of the following…

The gap formed here at “A” indicates potential support near the low portion of the gap. Knowing this fact, our trader would place a GTC SELL STOP order at or below the low range of this price gap to protect profits in the event the market turns.

The market continued to retest the support created by the GAP and eventually accelerated upward (at “B”).

This should have been a key factor for our trader as the acceleration created a new opportunity to adjust our protective Exit stop level and to secure additional profits in the trade. Now, the most logical placement of our exit stop order is at the Waist Line of the large range candle at “B”. This adjustment of our exit stop price level secures an additional $1.00++ in profits for our trader.

This type of strategy is basically a simple “insurance policy” whereas traders can attempt to lock in a certain profit level and leave the trade open in case the market continues to rally or sell-off. The thing to remember here is that it is a way of protecting traders from unwanted losses. Why is this important? I don’t know of anyone that wants to give away money – do you?

Exit Strategy Example #2 - Scaled Exit Stop

A scaled exit stop strategy consists of placing two or more GTC STOP LIMIT orders in a specific order to attempt to lock in a portion of the gains in the trade and let the remainder stay active until a secondary stop order is reached. This concept may be a bit difficult to understand, but I will try to make it easy. Let’s say we purchased a stock at $10 and it is not at $17 and is beginning to look weak. The scaled exit stop trades would allow us to liquidate a portion of our shares at one price (to lock in some profits) and the remainder at a lower price (to protect against unwanted losses).

Let’s assume we purchased 2000 shares of this stock at $10. So now we might enter a GTC STOP LIMIT ORDER to SELL 1250 shares @ $16.50 as our first Scaled Exit Stop Strategy and a GTC STOP LIMIT ORDER to SELL 750 shares @ $16.00 as our second Scaled Exit Stop Strategy. This would result in $20,635 gross amount of profits from this first scaled exit trade. Balance this against our entry purchase amount of $20,000 and we have a $625 profit from the trade and still have 750 shares in a open trade in the market.

Now, if the market rallies from this point, our 750 shares are accumulating more profits. If the market sells off to (or below) $16.00, our second scaled exit stop strategy will be executed. This second stop order would result in $12,000 profits (750 * $16.00). This trade would act as our insurance policy to protect profits whereas the first trade acted as a balancing technique to lock in our initial capital we used to purchase the original shares.

Traders can adjust these values and levels accordingly to meet their needs. In this example, I choose to illustrate the perfect example where our trader had accumulated enough profits to execute the first scaled stop order and recoup the initial purchase price. This is not always the case. Sometimes, traders must identify a scaled exit stop level where the amount returned is only a portion of the invested equity. This technique should be used when the trader wants to protect the trade and the initial purchase equity, but still leave a portion of the trade open for potentially further gains.

Now, lets look at a real life example with our COSTCO chart…

Using the same chart from example #1, we’ll simply employ a scaled exit stop strategy with the assumption we purchased 1000 shares at $34.50.

Using this example and assuming our trader has held on to the shares through the candle at “B”, our example trader would have achieved a profit in the trade of about $6,800 above the purchase price of $34,500 – nearly 20%. Using the same strategy as our hypothetical (first) example, if our trader wanted to protect his initial purchase price equity in this trade, the trader would need to place a GTC STOP LIMIT ORDER to SELL 870 shares at $40.25 (the level at “B”). This would result is a return of $35,017.50 – covering our $34,500 purchase price and netting a profit of $517.50. This also leaves 130 shares still active in the market and LONG. Our trader would have also placed a GTC STOP LIMIT ORDER to SELL 130 shares at $38.90 (the level at “A”). When the market fell to this level, our trade would have been executed and resulted in a $5057 profit. These two trades would have resulted in $40,074.50 in sales against our $34,500 in costs – or 16% return on investment.

You might be asking yourself “why doesn’t the trader simply sell all the shares at the high of the chart and maximize the profits”. Well, this is easier said than done. The way I explain it is “if it was easy to pick tops and bottoms correctly, everyone would do it and everyone would be super rich – right?”. Well, it is not easy to pick tops and bottoms. In fact, it is almost impossible to do it with any degree of accuracy. As traders, our primary function is to make educated trades based on our understanding of the market conditions and potential. Our secondary function is to protect our equity from losses and to protect our gains from losses. If we can do this effectively, then we can sustain a long-term relationship with the markets and potentially profit from our efforts.

Exit Strategy Example #3 - Net-Reverse Exit Stop

A net-reverse exit stop strategy consists of placing two trades that effectively exit an existing position and reverse (with a new Short or Long trade). This strategy should also be followed with ENTRY PROTECTIVE STOP ORDERS to protect against losses. This strategy is also a bit more advanced and I suggest that new traders simply wait for a timely entry signal instead of trying to “net-reverse” with every trade.

The “Net-Reverse Short” order is simply a series of orders that effectively exit a current LONG trade and a second order that enters a reverse (SHORT) trade. So, if our trader was LONG a stock and wanted to “net-reverse” as a price, our trader would place a GTC SIMPLE EXIT STOP order to sell all of the shares at $xxx.xx price and would also place a GTC LIMIT ORDER to SHORT the same number of shares at the same price as the previous order. The net result is exiting the previous LONG trade at n price and entering a new SHORT trade at n price.

The reverse of this scenario is to “Net-Reverse Long” trade would simply exit our of a SHORT trade by CONVERING the SHORT trade and then using a GTC LONG LIMIT ORDER to enter a new LONG trade.