Don't you know that it is important to limit risks.
By risks, we mean the mark of exit from the market in case it goes against. In this blogpost you will learn how to do this, after the exit the price does not turn back, and does not follow the direction in which you’ve moved earlier.
Risk limitation is also based on the properties of support and resistance levels.
Let’s suppose you see how the price has pierced the resistance level upwards on the daily timeframe. What are our actions in terms of risk limitation.
Three ways to limit risks:
- When the support or resistance level was formed
Based on the formed level, Stop Loss is placed in advance. The principle works according to the same rules of trend turn:
For example, the current support level passes through the $99 — 100 zones. Stop Loss, like Take Profit, is placed with a small margin from the level in case the price will test the level, but will not pierce it:
After the breakthrough of such mark, the market will not immediately start to grow.
Stop Loss mark is limited by two tasks. On the one hand, it should be as close as possible to the opening price, as close as it is possible. On the other hand, it is far enough away from the opening price, in order not to lose money during a normal correction, which may occur according to the logic of the properties of support and resistance levels.
How to calculate the Stop Loss mark
The distance between the level boundary, and the Stop Loss mark can be calculated using the ATR indicator.
At the beginning for D1 trading, choose an ATR with a 96 period on the M15 timeframe. You should collect your own statistics with different ATR parameters.
In our example, the ATR with these options showed the value of 11, and we subtract it from the lower boundary of the support zone:
Users often ask what if “to protect yourself”, and put the SL on two or even three ATR values in order to increase the distance between it and the entry point. It is a bad idea. You see, a breakthrough of the mark below the support level will be a signal of a downward trend. If you’ve missed the exit with a calculated risk (loss), then you should not sell at Panic Sell, the price sooner or later will “grow”. Your funds will be frozen, and you will watch them fading away. To avoid this, plan in advance the size of the loss according to the principles of the ratio of profit and risk, and set the Stop Loss correctly.
The principle works for both ways of trading: on the breakthrough and on the rebound.
A small task. Let's say the market shows the following:
The price has reached the resistance level, and beats off it. A buy signal was formed around $100.50. Where should you put Stop Loss?
In the same place as in the previous example, at $98.89:
If the market continues to decline, and breaks through the support level, then we can say about a trend change*.
* What is the catch: manipulation vulnerability
Sometimes in the market such situations may be formed:
With the help of a huge shadow, all stop orders are pulled out from the market. The players put them in approximately one zone. After that, the price returns to the original direction. Avoid it, unfortunately, is impossible. You are able to plan risks in advance. If you calculate in advance the appropriate loss, and follow your calculations strictly, you remove the risk of losing capital due to such manipulations.
It is impossible to avoid it, but you can use another Stop Loss option as soon as the candlestick is closed.
- Upon trend reverse
Installing Stop Loss at fact of closing a candlestick is below the support level or above the resistance level.
In this case, you do not place a stop order in advance, but exit the market only if you see the fact that the price in fact has gone against you, and the trend has turned:
Still do not fix the loss
In this example, the trend turns if the price closes below $99. In fact, if the support is pierced downwards:
At this point, you close the position with a loss.
Pros and cons of this way of trading without a pre-set Stop Loss:
- You are not afraid of the manipulation described above about pulling off the market.
- You can not accurately calculate the risk. It is fraught with a big investment. Once the candlestick closes at a distance of one ATR from the support level, the market will slide down quite actively. You will have to close with a much larger loss than you’ve planned.
— Maybe there are methods to estimate the probable exit point from the market? — you may ask.
— Maybe — we will answer.
As you remember, ATR shows how actively the market moves within each candlestick. This gives an idea what should you expect from the market. In order to experience this, calculate the ATR. In this case, on the timeframe where you enter the market: if you trade D1, it means ATR on the D1 timeframe. Period 15 is appropriate one. You will get a value that shows you the gap:
It will be greater than the ATR value for a set Stop Loss: as you remember, in the first method it is considered on a shorter timeframe.
Focusing on the data, you will be able to estimate appropriate position for a particular situation, and possible risk that you’ll have in such order.
- Stop Loss before the level forming
Installing Stop Loss on the unformed level works only on rebound trading, and does not suit everyone.
How it works:
you can see that a signal is formed on the rebound: the market has pierced the resistance level, rolled back, and then the bullish candlestick formed again. After it, the price can move upwards again. If this happens, a new support level is often formed near this first bullish candlestick. Then the lower edge of the shadow of the candlestick, $100.25 mark will be the lower support line:
This is a potential support level. It is still forming, it may not complete.
So, the third method of Stop Loss installation suggests installing SL below the possible level:
Please note that here the ATR can be considered on a shorter timeframe.
Be careful: this is the most aggressive among all types.
What is bad about using a fixed stop loss?
Fixed Stop Loss is a stop order set at the same distance from the entry point. A trader always closes a position at the same distance from it.
This may lead to the loss of your trading capital, because this fixed figure rarely fits the market situation.
Why fixed SL isn’t working
- It does not take into account signals of support and resistance levels. The majority of market participants are guided by them, making decisions.
- The market moves non-linearly. For a while it can go against you, this is OK. If you set Stop Loss not on the basis of levels, then this natural volatility can knock you out of the market. You will fix the loss, and after the price will start to grow:
- Risk limitation is a calculation of exit points from the market with a loss, if the market goes against, based on the properties of support and resistance levels.
- The first method is to limit risks via the Stop Loss installation at the opening of a transaction. It is suitable for trading tactics and rebound, and breakthrough.
- The second method suggests exiting the market after a trend turn. We must be patient if the price moves against us, forming a huge shadow. The method involves exit from the market due to the fact of closing the candlestick above the resistance level, if we are talking about sale trading, or below the support level, if we choose purchase trading.
- The third method is the most aggressive one, but it gives the best ratio of potential profit to risk. This picture shows two ranges:
This is the distance between the entry point and the lowest border of the first and the third methods (from left to right).
- Large Stop Loss makes the ratio of potential profit to risk worse.
- Fixed stop orders do not work.
- If you lose money if the trend does not turn during small market movements, that means that you set Stop Loss incorrectly.
There are other methods for risk limitation. But these three methods are enough as a start. Practice, and may the profit be with you 👾
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