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Risk and Trade Management - Stop Selection, Scaling Out, and Setting Profit Targets
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Ihis chapter will walk you through the various types of stop orders and when and where to place them. It will also provide a great deal of important information on why and which stops should be placed at critical price levels and how to identify those price areas. If a trader is to maintain a degree of profitability over time, managing risk and using a sys tem that helps evaluate price changes are critical. When you have finished this section, you will understand how to select stops to limit your potential losses and how to let profits ride. The process in selecting stop placement as a risk management tool starts with the price of where the trade was ini tiated. Here are some finer points on the rationale for using a risk method or for having a stop-loss system in place.

• Predetermined stop-loss orders help conquer emotional interference.

• Stops should be part of a system or included in a set of trading rules.

• Weigh the risk/reward ratio before entering trades; set a stop objective.

• When volatility is low, stops can be placed closer to an entry level.

• When volatility is high, stop-loss orders should be placed further away from the entry level.

One of my favorite bits of advice I give students and seminar attendees is that the first rule of trading starts with the premise that it is okay to form an opinion on a gut feeling; just act on a trade signal that substantiates that opinion. Write your rules down and have them posted on your trading screen on your computer. Before you enter the trade, check your rule list

twice; and make sure you know why and where to place a stop. As you gain more experience in the business, you will undoubtedly get caught in a news-driven, price-shock event, if you have not already experienced one. These are unavoidable and are hard to escape unscathed. It is consid ered a cost of doing business and should not reflect on your abilities as a trader. Managing risk is your job, and capturing as much profit as possible from winning trades should be your utmost goal. The descriptions of the types of stops and the pros and cons of each should help you make the right decision for the various circumstances or market conditions. In Chap ter 1, we did cover a lot of material, including economic reports. These news releases do cause price spikes; and I want to repeat, it will be in evitable that if you trade or have a position on before a report, some time in your career, you will experience an unfortunate adverse move against you. Remember, stops cannot be guaranteed. This chapter will give you the general knowledge of what to expect and which type of risk protection method you can use.

PLACING STOP -LOSS ORDERS

Stop orders are often placed to protect against losses. These orders can also be placed to enter positions. Specifically, a stop order is one that you place online in the FX market if the market trades at a certain price; then the order is triggered and becomes a market order to be filled at the next best available price.

• Buy stops are placed above the current market price.

• Sell stops are placed below the current market price.

I will focus on protective stops used to offset a position and to protect against losses and against accrued profits. Stops can also be used to enter a position. A variety of stops can be used depending on your situation, on the market you are trading, and on what you are trying to accomplish. Various types of available stops and several techniques can be used with them to help you manage your position and reduce your overall risk.

Dollar Limits

Stops can be based on a dollar amount per position, which is categorized under a strict money management system. If you are risking $250 per $100,000 lot position in a euro currency, then your stop level would be placed at a 25-point distance from your entry price. This method is used less frequently by professional traders because it has no relevancy from a

mechanical trading model. However, there are benefits to this feature with setting a daily dollar amount on a loss limit for active day traders. Some electronic order platforms allow you to set a daily loss limit. Rather than per trade, it sets an overall loss limit on your account.

Percentage Figures

Most traders hear of using a stop of a certain percent of the overall account size. Generally speaking, that number can be from 2 percent up to as much as 5 percent of the overall account. Unfortunately, for most traders in forex, the average-size trading account is $10,000, which is $200 to $500 per trade. This leaves little room for error. Normally, traders want to use at least a two-to-one risk/reward ratio on their trades or have a statistical reason for a large risk amount that is consistent on each trade such as we have in our trading system discussed in Chapter 8.

Time Factors

After a specific time period, if the price does not move in the expected di rection or if the velocity of such a move does not warrant holding onto the position, then exit the trade. If you see a low close doji (LCD) or a high close doji (HCD) trigger, you have experienced that the market generally demonstrates immediate reaction. If after a long period of time (which could be defined as three to five candles) the market does not respond to the signal, then liquidate the position. The timing of the trade did not cor respond with the desired or historical past proven results. Another consid eration in the art of stop placements using a time element is the aid of a moving average. If you are long and the market starts to close below a moving average value, then exit the trade.

Once again, moving averages are simply trend lines that are considered a time-driven price-direction tool. One time factor that you can use as a stop placement method is the crossover point of reference created when using two moving average values—once the shorter-term moving average crosses the longer-term, it reflects a value change in the market. In the chart in Figure 10.1, we have a spot FX euro currency on September 7, 2006 , which shows a classic LCD sell signal near the projected daily pivot point resistance level. Combined with prices closing below both moving average values, this is a textbook setup. The stop would be initially placed as stop-close-only (SCO) above the high of the doji. Now, this would need to be a visual stop because most FX platforms do not accept intraday SCOs. So you need the discipline to exit as a market order, in other words, to buy back the short position at the market once prices close above the doji high.

We should see immediate results with this trade; and as prices respond favorably and move lower. we can place a hard stop above below the doji high. Once again, you would want to look at the point of crossover of the two moving average values. If the market closes back above the high of the doji or those moving average (M/A) values, then a trigger to exit the posi tion would be warranted. As you can see, a bearish trend develops with the golden sequence of events consisting of lower highs, lower lows, and lower closing lows and closes below the opens. I want to point out that the indi cator showed the sell signal first in this case, at 128.12; the stochastics gave a signal with the %K and %D values crossing and closing back beneath the 80 percent level just one candle later at 127.97. But notice the zero-line crossover of the moving average convergence/divergence (MACD), which triggers the sell signal much later at 127.75. The stochastics was more in sync with the LCD trigger.

The difference between the pivot points moving average method and the MACD trigger was 37 PIPs (percentage in points), which on some days is a decent trade all by itself. Granted, the market traded lower; in fact, see how prices traded just below the daily projected pivot point support target at 127.36. The tweezer bottom candles that look almost like an equal-and opposite pattern may have helped you decide to exit the trade had you taken this sell signal. The point here is that a trade signal was generated, the

stop mechanism is in place, the market responded according to the tendencies of a particular pattern, and a profit objective was reached. When markets move into trend mode, there is only one way to trade them: You have to wait until each time period closes to see confirmation that prices are in fact following a specific course of action. In a downtrend, that would be lower highs, lower lows, and lower closing lows or closes near each time period's low and closes below each time period's open. The way to capture the most profits is to initially set your stop and then trail the stop as the market moves in the desired direction. Trailing stops can be placed automatically on some trading platforms. You need to do a little homework here to determine the settings of when you want the stop moved and at what price level. For instance, you can set the amount for every 30-PIP de cline below your entry level; your stop will be moved lower by 10 PIPs. Mar ket conditions warrant where you place your stops, such as if the market gives you an immediate windfall profit of 100 or 150 PIPs or so, it might be best just to take the money off the table.

Price Levels

Traders often use basic statistics to measure the degree of price volatility that can occur on a daily basis in a given market. These measures can then be used to place a stop or a limit order that takes into account these natural daily price movements. Statistics that are often used will be the mean, the standard deviation, and the coefficient of variation. The best trailing stop approach has been explored by many technicians. The various methods for this approach include placing a stop using a set price amount that could be as much as 150 percent of the average true range of a given time period either above or below the swing high and low point. Why is this method important? If you place a stop near a specific chart point of interest, such as an old high or an old low, those levels are obvious to every chart watcher. Markets do test and penetrate those levels from time to time. If you set your stop too close, such as setting a sell stop below an old chart low point or a buy stop above an old chart price high, chances are that your order may be executed if it is too close. So generally, a certain factor or distance should be calculated for your stop placement. Since most traders believe a market has reached a peak, they will place a stop slightly above an old high or below an old low. Depending on where you place your stop, the market may demonstrate a spike pattern that will hit your order and then proceed to move in the desired direction.

Generally, the market stops traders out and never looks back. In Figure

10.2, I have an example of how when the market is at major turning points, price spikes in the forex market are a common occurrence, especially right before some pretty big turns happen. Two stop methods can be employed that will help alleviate being prematurely stopped out. One is a stop-close only, and the other is taking the average daily range of the past 10 periods or more and using a factor between 120 percent and 150 percent of that 10day average daily range. On a buy stop, you would be looking to establish a short position and would place that stop-loss order by that calculation

above the highest high of the preceding target swing high. For example, if you take the average daily range for the 10 trading sessions prior to the high back on July 5, which was the first peak, the sell signal was triggered by a low close doji pattern. The rules state to initially place a stop-close-only above the high of the doji. Stop-close-only orders do not guarantee where you will be filled, just that you will be filled if the market closes above that price point.

Check with your FX dealer to see if it has SCOs and the time it consid ers as the close. You want to be crystal clear on this point. As a position trader, you can use this method on spot FX, on futures, or on exchange traded funds, such as the FXE. Remember that the risk amount would not be absolutely defined, but the SCO would be placed at 1.2823; the sell was triggered at 1.2703. That would be a risk of 120 PIPs. Two days after you en tered, the market prices did spike back and take out the high as shown at point B at 1.2862. The stop-close-only method saved you from the market's grips of getting bagged and tagged.

If you wanted to place a hard stop using the average daily range for the prior 10-day period, it worked out to 94.9 PIPs. Table 10.1 shows the break down of each session's high, low, and overall range. The spike top ex ceeded the prior high by 39 PIPs. By using the average true range of the prior 10 sessions and placing a stop above the initial high by that amount or even a factor of 120 percent, that would work out to 112 PIPs above 1.2823. You would be out of harm's way. The key is that you would need to place your stop at 1.29; and from your entry of 1.2724, that would be 211 PIPs, which is quite far away and certainly more than most traders would risk. Keep in mind that this is an initial risk order and that the next phase is to move the stops as the market moves in your favor.

Granted, depending on your risk tolerance, this may seem excessive; but you can select and back-test any percentage variable of an average daily

range stop placement. This method is used more for position traders, but the concept can be adapted for day traders. The key idea here is to keep your stops out of harm's way. If a trade is to become profitable, there should be signs: In the case of selling short, you see immediate results with lower highs, lower lows, and lower closing lows. Even in the days where you see spike highs or spike lows, notice where the market closes in relation to their respective highs and lows. The price penetrates the highs but closes back below the prior highs. The reverse is true at the spike lows. This is a good clue that the market has exhausted the trend and is ready to reverse. Keeping a stop out of harm's way will allow you to participate in the move using a variation of an average daily range stop placement.

Conditional Changes

This is my favorite method, and here is how I define a conditional change: It is the last higher closing high or lower closing low. Such as the case with a spike top, the market does not close above an old high. Therefore, one factor such as the SCO order will be of great use to a trader not looking to get bumped out of a position. There is, as with any stop, the unknown risk that there is not a guaranteed price at which your stop order will be filled. This order has a negative connotation among traders as it spells out too much risk. A buy stop will be elected and knock you out of a position if the market closes above the stop price; and a sell stop will be elected and knock you out of your position if the close is below your selected price level. The unknown is how far away the market will close from the selected stop price. The key benefit in using a stop-close-only is that it keeps your risk defined to a conditional change and helps you from getting knocked out of a position from intraperiod volatility. SCOs are for end-of-day trading and can be placed on most trading platforms. The concept can be used for day trading; however, it must be used manually because most platforms do not accept intraday SCOs. Some consider this as a mental stop, which is a predefined risk factor. However, many traders violate the rules once a sig nal gives an exit; they don't exit, and their losses are increased.

The challenge in selecting the right stop is to not be shaken out of the trade by market volatility. A variable may be used to place trailing stops that adapt to market volatility, which combines enough sensitivity to price changes with flexibility to fit your trading needs. Using this combination, in fact, may well provide an extremely profitable stop for the intermediateterm trader. Trailing stops are used in an attempt to lock in some of the paper profits that could accrue should the market move in the direction de sired. Like an ordinary stop, the trailing stop is started at some initial value; but then it is moved up (in a long trade) or down (in a short trade) as the market moves in your favor. It is important to try to maximize your trading results and to stay in profitable trades as long as possible. Employing stop losses and profit targets of the wrong sizes can ruin a trading strategy, mak ing it perform significantly worse than it would have otherwise. Testing has demonstrated that a proper combination of even simple exit methods (such as placing sell stops below the low of the past two days when going long) can substantially improve the behavior of a trading strategy, even turning a random, losing strategy into a profitable one! Another less com plicated method to use for a bullish trending market condition is to place a stop below the lowest low from the past 10-day period. Another one of my favorite methods is a trailing stop using the lowest low or the highest high from the last conditional change candle. I define the last conditional change as a higher closing high or a lower closing low. This is a much more important event than a higher high or a lower low since those price points are simply spikes. Buyers who stepped in on the open have a strong con viction that prices should expand to new higher territory once the market established a new high ground; and when the close is higher than the open and the market closes higher than a previous high, then the market is demonstrating significant strength. When you see a lower closing low as the lows are violated, then the market is demonstrating significant weak ness. In turn, under these conditions, we should expect to see weaker or lower prices.

Let's examine this conditional change method on a day trade with a chart example using the spot euro currency from July 10, 2006 , using a 15 minute time frame. Figure 10.3 shows a low close doji trigger to sell short at 1.2796. The initial stop per the LCD trigger states to use a stop-close-only above the doji high. That would be 1.2812. As you can see, the market stalls in a traditional sideways channel that the forex market is famous for; but it never really gives any pressure on the trade. As the sideways channel forms, at the end of the channel, notice that another low close doji sell sig nal materializes; and this time the market closes below the channel support trend line multiple times.

According to the trading rules, your stops should be placed initially above the doji high. If you were short from the first signal, then use the sec ond doji as your stop point still using the SCO method. Once prices start to move lower, trail your stop above the highs of the candles that make new lower closing lows. At the end of the run, we want to trail the stop above the high of the last conditional change candle that made a lower closing low. If the market is to remain bearish and continue in a bearish trend mode, we should not see the high of a conditional change candle tested. Generally, when we do, that is a sign that the market condition will either enter in a consolidation phase or will reverse. Either way, it generally marks the time to exit the position.

SCALE IN ENTRIES AND SCALE OUT EXITS

One of the single most important habits that some successful traders have is that they possess a method that helps them define where the market should go each day or they follow a game plan. They may possess a system or use a method that provides an accurate daily forecast. They also may have a set of rules for when to get in and out of the market, which may in clude a set of timing indicators to help them to pull the trigger at the key areas. But above all, they possess discipline to follow through with these rules. Trading is about making money, not about being correct in market analysis or being a great prognosticator. Traders must be consistent in their approach and strive to completely remove emotion from trading decisions. This is often best achieved by having and sticking to a plan for every trade. Trades are made in the current market, not in the past market. Hindsight is always twenty-twenty; keep in mind that you will never trade as well in real time with real money as you will by looking at or trading in the past. Trad ing in the past is an exercise in futility that will only harm your psyche going forward.

You should view every trade you make as the best trade you could

make at the time with the information available. That is why I like to scale out of a portion of my positions at key spots that guarantee money in my ac count while allowing me to participate in further gains. The reason I like to keep a portion of positions on is simple: As good as my triggers can be, I cannot predict the future. I do not know if a market will go into a consoli dation phase or if it is simply pausing before continuing the trend or getting ready to reverse the trend entirely. Therefore, it is crucial to take money off the table when given the opportunity, while letting a trade mature and po tentially develop into a larger profit.

There is only one way I know how to manage such a feat, and that is by scaling out of partial positions. The question some traders ask is, “What is the formula or percentage that I use to take positions off?” I normally use the 50 percent rule, but at times the one-third rule works as well. In order to define what the percentage figure is, I need to judge the condition of the current market environment. Ask and observe: Has the market been in a trend, a sideways range, a small-range low-volatile period, or a long-range extreme-volatility trading condition. Remember that trading requires you to ask questions and observe. The three critical stages for a trader are:

1. Gathering of information on which to make decisions.

2. Using that data to help formulate a trading idea.

3. Planning which actions to take.

The gathering of information involves collecting past data and then ap plying it to a specific means of market analysis, such as what I have cov ered using pivot point analysis. In formulating ideas, you may look at the pivot point moving averages to help determine a market's ability to trend by certain price direction. This step helps you to predict where the market might head, then gives you information so that you can decide where it should be going. Planning action involves thinking creatively about alter native courses of action, evaluating their feasibility, and making decisions on implementation of the plan. This step helps you decide if you should be in multiple contracts or if you should scale back on your normal position size. If the risk is not worth the reward, then trade with fewer positions; scale back your normal position size. Pivot point analysis helps give me a heads-up on the potential range of a session. The moving average of the pivot point helps give me a truer reflection of the market's value, and that helps me define the market's condition and possibly the correct direction. Candlestick charts help illustrate and define the trigger or the entry as well as the risk as indicated by past highs or lows. This enables me to carry out a systematic process of arriving at optimum plans and strategies for my trades.

With that, I am now aware of the full range of issues to be considered in a systematic thinking process before entering a trade, I can formulate a trade with a clear, concise strategic plan by examining a set of relevant questions: How low can the market go? What is the next support target? How high can the market go? What is the next resistance?

Exiting the positions and taking money off the table should be the easy part. However, as it turns out, that is the hardest part for most traders. Scaling out of positions is the most appropriate method when the market gives you a clue that the trend momentum is slowing. It allows you to capture a profit while participating in the market. The euro currency chart in Figure 10.4 demonstrates a nice day trading opportunity, and it shows how scaling out of half of your positions is a great mechanism to capture profits while staying with a potentially longer-term trend. As you can see, the sell signal triggers at 1.2872; immediately, we see the sequence of events, such as lower closes than the opens, lower highs, lower lows, and lower closing lows. This is what we want to see each time we place a short position in the market. I like to move my stops to just above the high of what I call a last conditional change (LCC).

When a candle makes a lower closing low, that is the inflection point in time that causes a market to continue lower. If not then, there is another conditional change. In other words, a bearish trend would change to bull ish, and I would want to be out of my short positions. Now, as we see prices decline, a hammer forms; and as you know, that is generally a clue that a market reversal is developing. In addition, notice that the low of the ham mer is pretty close to the daily pivot support level. The candle right after the hammer does make a higher high, which would give you reason to scale out of half of your positions at 1.2785. That would be an 87-PIP gain on half of the positions—not a bad trade over 1 hour and 45 minutes. The market has truly not given any confirmation of a trend change; therefore, you would want to move a stop down on the balance of the positions to just above the high of the candle that made the most recent major conditional change of a lower closing low. Trading with scaling out of the balance of half of your positions, combined with the trailing stop method we went over in the pre vious section, will help you capture profits while participating in the majority of a trending market condition.

A day trader looking to capture a portion of a day's potential trading range has to use a plan. Scaling out of positions is such a plan of action. By setting stops at critical points and scaling out of trades, you can enjoy the best of both worlds: booking profits and letting trades ride. In Figure 10.4, we have our final trailing stop placed at the high of the LCC candle, and a bullish piercing pattern does form the low. Accordingly, the trade is stopped out at 1.2750 for a 122-PIP profitable move on the balance of posi tions. Even if you have a minimum of two lots on, that is 209 PIPs for a day. If you are a small-size equity trader and just starting out, this would be a great example of why you should trade mini-accounts; if full-lot-size posi tions are too much leverage, knock the trade size down. If your trades have merit, you will be rewarded. Building equity takes time; but by proper risk management and implementing scale-out trading techniques, you will increase your chances for continued success.

Take a look at Figure 10.5; we have a spot British pound (cable) versus the U.S. dollar from May 11, 2006 . Notice that the market breaks below the targeted pivot point support several times; however, prices do not seem to decline very far or to carry any negative momentum. In fact, the market does what forex is notorious for—consolidates in a sideways pattern.

A doji pattern develops, which is actually the low of the session. Notice that the actual range of the doji (high/low) contains the majority of the price action. We do not want to take sell signals at support; so at this point, we need to wait for a definitive signal. There are two ways to enter the high close doji trigger: (1) using a stop-close-only below the low of the doji as in dicated on the chart with the dashed line, or (2) a trade signal based on a momentum breakout of the sideways channel. In either case, your stops should be placed initially under the low of the doji as SCOs. Once the market breaks out of the consolidation pattern and the pivot support line at 1.8591, you can place a hard stop below the doji low and follow the devel opments as the trade matures. We see higher highs, higher lows, and higher closing highs. The market closes closer to the highs of each successive can dle, and the closes of each candle are above the opens; all are very bullish signs. So far, you do not have a reason to liquidate the position or scale out of the trade. You can trail your stops below the low of the LCC candles. Here is an example in which if you are trading multiple lot positions, you can trail your stops on a portion of positions and put the portion at breakeven. If you choose to trail the stops in this example, notice the LCC candle: Not only does the market turn, but it also generates a sell signal. I would accept getting stopped out of the positions here, but I would not look to sell short for two reasons: (1) it is near support, and (2) the higher time frame 60-minute chart is still in buy mode.

If you entered late at 1.8569 and exited on your stop out at 1.8670, this is still a great day trade with a gain of 101 PIPs. As the saying goes, you can always reenter the market. As this chart shows, the system does generate a secondary buy signal, in which it gives you an opportunity to reenter a long position, which goes with the 60-minute dominant trend. The second trade would get you back in at 1.8656. Your stop should be placed below the reactionary low at 1.8615; and as prices forge higher, you can trail your stops below the low of the LCC candles. Follow the sequence of events that en sues: higher highs, higher lows, higher closing highs, and mostly higher closes than open candle patterns. The first clue to exit would be the pro jected daily pivot resistance level or once you see the first lower closing low. That happened at 1.8818, which is an additional 162 PIPs! This day gave two great signals; by following the flow of the market, you had the op portunity to take two trades using the LCC candle method to trail your stops. It ends a terrific, stress-free trading day.

I encourage you to explore any and all methods, but I will stick to what works for me. When I have a projected entry price based on pivot point analysis, I never have at any time a “guaranteed” profit until I liquidate the trade. By scaling out of a trade, it is the finest known method that puts cash in my account while allowing me to further participate in gains. Pivot points help target the entry and the exit on my trades.

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