One of the most difficult tasks that traders have is determining the right amount of risk exposure when entering a trade. Since every trade should be accompanied by a protective stop-loss order, the question always comes down to “how much room should I allow the market to move against me before getting stopped out?”
Some traders rely on previous support and resistance levels as a place to put their stops. However, often these areas are gunned for because floor traders know that there are plenty of orders waiting there for the taking.
Some traders will draw lines below or above sloping trends and use that as a stop-loss reference, often expecting the market to continue with that pattern. But then, how many times do we see that pattern get violated right when we discover it is there?
Others will use some percentage value, either based on some fixed profit expectation or a percentage of available funds, to determine their initial stop-loss.
There are many different approaches to picking a stop-loss. My personal preference and what I believe to be the best approach most times is to use the expected and confirmed swing price.
What do I mean by ‘expected and confirmed’ swing price?
As of 2019, it has been 30 years that I have focused on the science and mathematics of market behavior. More specifically, forecasting market swings (aka turns) in advance. This approach requires a firm understanding of several methods of forecasting, including the popular and well-exposed techniques involving Fibonacci and Gann ratios, to name just two. There are so many more!
By learning and applying various market timing techniques that are designed to expose the underlying cyclic behavior of the markets, the trader can then use this information to ‘shorten the risk exposure’ of any given trade.
Here is how this works.
Suppose by way of using some proven method of determining high-probability market turns you arrive at the expectation that a swing bottom is highly likely to occur in the next day or two (at the very latest). Your method is usually 80% or better in accuracy, so you do not have to concern yourself with whether it will be on time (say tomorrow), or one day late (the following day).
The reason for this is that, since you already know with a high degree of certainty of the probability for the swing bottom, you simply place your ‘buy stop’ order for entry to go long just above the high price of the day you expect the swing to occur. If the order is triggered, you immediately place your stop-loss just below the low of that same bar because it just ‘confirmed’ as a swing bottom. Your initial risk exposure is the range of that swing bottom price bar. The probability that it will hold and not get you knocked out with a loss is very low because you knew with high-probability that the swing bottom was going to occur on that day to begin with.
Now suppose that the swing bottom is going to be one bar late as earlier stated as possible. In that case, your buy-stop was not triggered and you can do the same routine the next day for the one-day late bar. Same rules apply.
The real trick, once you are in your trade, will be on managing the trade and adjusting your stop-loss as your position moves deeper and deeper into profit territory. That is a whole different subject for a whole different article. But for the subject at hand, finding the right time and price to put on your initial stop-loss order where it is not too small or too large is not only also important, but it can save you a lot of money, keep you in more trades, and keep you out of trades you later are glad about.
So in order to have these advantages, to begin with, learn how to forecast market turns or find a reliable source for this information.