Trend Trading - The Breakout Trade (Part V) - The Initial Stop

If you Buy at 750 and you are prepared to lose up to 5 points on the trade, you can enter a Sell Stop order at 745. If the market price moves down to 745 (or lower), the Sell Stop order is converted into a Market Sell order and you exit your trade for a loss.

Conversely, if you open a short trade at 750 with a Sell order, you could enter a Stop Buy order at 755. If price rises to 755, the stop order is converted to a Market Buy order and you exit the short trade for a loss.

That is the theory, but it is not perfect! The problem is that there is no guarantee where a Market order will be executed, and there is no guarantee that price will move gradually in one direction or another...

For example, your Sell Stop order at 745 might get executed (filled) at 744.5. That makes your loss half a point (10%) bigger than expected.

Even worse, bad news could hit the market! Suddenly, price drops to 740! Your stop is triggered, and you are filled at that level. That is a 10 point loss, double what you anticipated! Things like this can and do happen more often then you would think, but the risk is greatest if you have a position open overnight or through weekends.

The day trader is much less likely to experience a catastrophic loss due to a big "gap" in the market, and that is one reason why I consider day trading to be one of the safer forms of trading activity. The day trader will certainly experience slippage losses, but they can be anticipated and accounted for.

I never enter a day trade without a stop loss order in place. Some people disagree, but with me it is an article of faith.

Even though a stop loss order is not a perfect tool, it is still a very good form of insurance. The day trader, often undercapitalised, MUST acquire protection against being wiped out by one bad trade.

People who dislike the stop loss order point out that sometimes markets seem to reverse and take out your stop, before accelerating away in the direction of your original trade. You end up with a loser instead of a spectacular winner...

True! That does indeed happen all too often. However, all insurance costs money, and it is best to write these instances off as your insurance "premium" against a disaster. Experienced traders do not even consider the "what might have been" scenario, they just accept that they had a losing trade.

So, given that we must have a stop loss order, where should we put it?

There are many approaches. One of the simplest is the money stop. With this approach, the trader decides what percentage of capital can be risked and puts the stop at a distance from the entry which would equate to the risk percentage (or a little less).

For example, if you are prepared to risk 3% of a $10,000 account, that is $300 in one trade. With the S&P 500 E mini contract each point is worth $50. If you are trading one contract, your stop could be six points away from the entry. If you are trading two contracts, the stop could only be three points away from the entry.

That is okay, but I prefer to make use of the information on the chart. By the time we enter a trade, we have significant information, and it seems a pity not to make use of it. Since the breakout trade is entered during a pullback after a trend is detected, we know some of the short-term support and resistance levels in the market.

The depth of the pullback is a very significant measure. In an up trend, the session high point is clearly the resistance level, and the low point of the pullback is the short term support level. (I usually refer to this distance - between short term support and resistance - as R.)

Putting a stop one point below the support level is a (fairly obvious) valid position for a stop loss order. The logic is that if support is penetrated, our long trade is no longer valid.

Some people use various multiples of R has their stop. Especially if they subscribe to Fibonacci theories. They may take a view that, once resistance has been penetrated, any subsequent pullback should not exceed (for example) 68% of the most recent move upwards - so they put their stop at 0.7R below the entry.

More conservative traders might place a much wider stop, say 2R below the entry point.

Obviously, the wider the stop, the less likely it is to be taken out by random fluctuations. In other words, with wider stops you get more winners.

On the other hand, with a wide stop you stand to lose more if it is taken out. So you can not afford to trade as many contracts and your wins will be smaller...

That is the dilemma of the trading system designer. It is up to you, the day trader, to decide where the sweet point lies in this delicate compromise.