In our last lesson we learned about the Average True Range (ATR) and how traders use this to get an idea of the volatility in the market so they can incorporate this into their stop levels. In today’s lesson we are going to add an additional factor that most traders consider important when setting stops, support and resistance.
As we have learned in previous lessons many traders will use technical analysis to determine where support and resistance is in the market, and look for trading opportunities based on what that chart analysis tells them. In addition to using technical analysis to find support and resistance levels in which trades can be entered, many successful traders also use this method of analysis to determine where their stops should be placed.
One of the most popular methods which we have touched on in previous lessons where many traders use support and resistance in their (stock, futures, and forex trading strategies) is when trading ranges in the market. Many traders favor ranges, as they provide traders with the ability to enter trades with tight stop losses and much larger potential returns. The reasoning here is that traders can enter a trade just below resistance or just above support in the range, place their stop just outside that level and then their profit target at the other end of the range. Generally the distance between the stop level is much shorter than the distance between the other end of the range, providing traders with a great opportunity for a relatively low risk and potentially high reward trade.
This is also another example of using tech levels (the bottom and top of the range) to place trades and set stops. Often times however as many traders are employing this type of trading strategy, the market will jump up or down above/below the resistance/support level stopping traders out of trades before quickly reversing and moving in the favor of the traders original entry price. Because of this traders are faced with the dilemma of how far to place there stop outside of the range that they are trading, so that they can be in a position where they are protected but are less likely to be stopped out on market spikes. One way that this can be done is by incorporating the ATR.
Although the example above shows 1 ATR. as the level at which the stop is placed outside of the range. That number could be a percentage such as 50% of the ATR. or any other multiple of the ATR such as 2 ATR’s outside the range, depending on the traders time frame, profit target, and strategy.
To finish off this example we now have several components which make up a basic strategies for placing stops based on technical levels and can now analyze the feasibility of one of the trades here to see if it fits all of our criteria.
So in this instance with $10,000 in trading capital and our 115 point stop we are not only well within the recommended 2% loss limit, but we also seem to have a healthy profit ratio on the trade.