Initial Stop Loss

The placement of your initial stop loss is important because it performs two important functions. One is to get you out of the market if the trade is not doing what it should. In other words, if the reasons for entering the trade are no longer applicable, you should exit. Two is to preserve capital.

In this section we’ll cover the various stops you could employ, and in a later section then look at how this affects your risk and position size.

The two stops we’ll look at are:

• Previous high/low stop
• Volatility stop

Previous High/Low Stop

You position your stop based on recent price action. A perfect example is if you were to use 3 day isolation low as a trigger, the stop loss can go directly below the low point of the 3 day isolation. The market has already said it sees this low point as significant.

Volatility Stop

This stop method takes into account the volatility of the market by measuring its range in price. A more volatile market needs a larger stop to allow the market to move freely without triggering a stop too prematurely; where as a non volatile market does not need so much breathing space.

Range is determined by measuring the distance between the high and the low of the price bar. An indicator called Average True Range, or ATR allows you to plot this range as an average over a period of bars. This in turn becomes your volatility.

For example, ATR (30) will display the average true range over the last 30 bars. What’s more the ATR takes into consideration any gaps, hence the name average ‘true’ range.

After determining the volatility, the trader must determine the multiple of volatility to use. The size of the multiple depends a lot on your trading style; a growth trader will use a higher variable to a revenue trader.

Example:

• Revenue trader – 2 * ATR (10)
• Growth trader – 5 * ATR (30)

So if the ATR (10) happens to be 2, and the trader decides to use 2 * ATR (10) for their stop loss, they would put there stop 4 away from their entry price.

Here is an example:

The entry price is $76.60. The current ATR(10) reading at the time of entry was .84. Multiply this by 2 = 1.68, which is the distance from entry we'd place the stop, in this case 76.60 - 3.32 = $74.92.

There are other methods you can employ such as dollar stop where you place your stop a dollar amount away. There are percentage stops where you determine the percentage a market will move before you get stopped out. In fact there are quite a few personal ways you could choose.

A significant point to consider is that the smaller the initial stop loss is, the more losses you will have compared to wins, but the losses will be smaller. This in effect means you can place more trades at once. Both points affect the trading style of the trader.

Move on to Step 4 - Module 2 > Trading System Builder Tool Kit: Trading Rules > Terminate: Exit Strategy