In our last lesson we learned how many successful traders look for entry opportunities which allow them to set their stop so that there are multiple support or resistance points between their entry point and stop level, and few if any support or resistance points between their entry price and their target. In this lesson we are going to look at another factor that many traders use when deciding where to place their stops, the use of technical indicators.
In our previous lessons we covered two indicators — Average True Range (ATR) and Parabolic SAR — and went over specific trading strategies on how they can be used to set stops. While these indicators were designed specifically to help traders gauge where to place their stops, many of the other indicators which we have looked at using to pick trade entry points can also be used to decide when to exit a trade.
With this in mind the question then becomes: with all the options available how do you choose which indicator if any to look at when deciding when to exit a trade? Which indicator, if any, you choose to include in your money management strategy for setting stops is going to depend largely on the type of stock, futures or forex trading strategy that you are trading. As a general rule however if you use an indicator to signal for example a buy entry on a trade most traders will keep an eye on that same indicator and take into account when that same indicator signals to exit a trade.
As an example of this, lets say that your analysis of the Average Directional Index (ADX) shows that the chart of x is about to start a nice trend and you decide to place a trade on that analysis. Using the knowledge you have gleaned from our lessons on stops so far you also pick a level for your stop which has some nice protection and is close enough that it fits within your two percent loss limit. During this trade however if the Average Directional Index (ADX) which is the indicator you used primarily to enter the trade begins to signal that the trend is weakening and the market is about to range, should you remain in that trade? The answer to that question is going to depend on the strategy and what other things are going on in the market at the time, but I would say at minimum most successful traders would take this into account when deciding whether or not to continue with the position, regardless of whether their stop had been hit or not.
Lastly on this point there is one indicator that so many traders watch that many traders will at least keep an eye on what happens with this indicator and that is the 50 and the 200 day moving average. These indicators are in general thought to be representative of the overall trend in the market and a break above or below these levels and/or a crossing of the 50 day moving average above/below the 200 day moving average is normally seen as significant for a market and as such many traders will take this into account and place their stops accordingly.
As you probably have noticed when thinking about placing stops using indicators, as you don’t know where price is going to be when your indicator signals for a trade exit, you do not have a hard stop in the market, are in the very bad position of not being protected in your trade. This is why, as we have talked about many times in our other lessons, that if this method for setting stops is used it should always be used in conjunction with another method which allows you to set a hard stop and stays within the 2% loss limit rule we have established.
This concept of the stop being a sort of “moving target” is a nice lead in to our next concept and lesson where we are going to be talking about what is known as a trailing stop.