The previous lesson covered how to set a stop loss using a percentage of your account balance.
A more logical technique to set stops would be to look at what the charts are telling you.
We might as well base our stops on what the markets are showing us because we’re trading them… Doesn’t that make sense?
One thing we can notice in price activity is that there are times when prices don’t seem to be able to push or break through particular levels.
When these areas of support or resistance are retested, they can potentially prevent the market from moving forward.
Setting stops above these levels of support and resistance makes sense because, if the market trades above these levels, it is logical to believe that a break of that area will attract more traders to play the break and further drive your position against you.
Or, if these levels do break, it is possible that forces you are unaware of are suddenly driving the market one way or another.
Let’s take a brief look at a method for determining support and resistance:
The pair is now trading above the declining trend line, as shown on the chart above.
You determine that this is an excellent breakout trading scenario and decide to go long.
But, before you start your business, consider the following:
Where could you possible set your stop?
What factors would indicate that your original trading proposal is no longer viable?
Example: Short EUR/USD
The EUR/USD has been going downward in the chart below. Price has crossed the declining trendline several times, forming a good resistance level.
A short order could be placed right at the downtrend line (1.3690).
Where would you put your stop loss now?
Your stop would be set at 1.3800.
Take note of how this is above the point of resistance: the declining trendline.
Set profit goals of 1.3530 and 1.3450.
The deal has been initiated. Price declines as the trendline holds as resistance.
Your first profit target has been hit.
The second profit objective is missed by a single pip, but you had already increased your stop loss to breakeven (where you entered short), so you lost nothing.
This is an example of using resistance as a guide on where to place your stop instead of simply using a fixed number.