Rookie Corner : The Mechanics VI
Did you find a stop loss technique that you liked? Did you actually use it? One of the biggest problems for new traders is learning to take a loss. Most people think that if they learn enough about the markets and how they work that they won’t have losing trades and that their equity curve will be linear, or in other words a straight line up on a 45-degree angle. This couldn’t be further from the truth. Think of yourself as a professional golfer, do professional golfers hit every tee shot perfect every time? No, they don’t and they also know that they won’t so they act accordingly and they practice getting out of tough situations so that when those inevitable errant tee shots sneak in they can still salvage par and put themselves into a position where they still have a shot to win. That is what we do as traders, we learn what we can about the markets and how they work and then we come to the understanding that we will NOT be right on every trade and then we act accordingly by putting in stop losses to prevent our accounts from getting blown out and therefore we get to put in more trades and we are only one good trade away from our next winning trade.
So now that we have our Entry price and our Stop loss we are able to figure out our risk from those two pieces of information Now we get to the fun part, how much do we realistically think we can make on this particular trade. This is where we use our best judgment to determine where the equity can get to before running into some form of resistance. This is our Target number. We can never really know where a stock will go and how far but we can make educated guesses using technical analysis and that will get us in the ballpark and then we will be able to calculate the reward part of the risk/reward ratio.
If you look at the chart of AAPL below you can see that I have circled the most logical support in yellow and we used this as the backstop for our Entry price and you can see that I have circled an area in green. This would be a logical place for AAPL to run to, as it was resistance before and we must believe that it is possible that it could be resistance again. This is one way to pick a target. Now AAPL could run further than this but it could stop there as well so all we are trying to do is pick a logical spot for an equity to reverse. This can be done by looking at former resistance levels or this can be done by looking at how far the stock has run each time in recent vintage. For example, if XYZ stock tends to run an average of 10 candles each time it goes up after a pullback and then pulls back again then it would be logical that it could act that way again. There are a few other ways to pick targets such as Fibonacci extensions or other some other indicators like Bollinger Bands, but that is a conversation for another day. The most important thing to take away from this is that we need to pick a logical spot and use that in our calculation to figure out the last part of our formula for trading stocks.
So here is the math for our AAPL example, our entry price is 10% of ATR above the high of the previous candle. In this case, the high of the previous candle was 173.92 and our ATR was 4.04 so therefore our entry price would be 173.92 + .404 = $174.32. Our stop loss was 10% of ATR below the previous candle which translates to $172.66–0.404 = ~ $ 172.26. So now we have our entry and our stop and our target resistance sits at around 180.
So we can now do our risk/reward calculation to see if this is a trade we would like to get involved with.
RISK = Entry — Stop Loss = $174.32 — $172.26 = $2.06
REWARD = Target — Entry = $180 — $174.32 = $5.68
RISK/REWARD ratio = REWARD / RISK = 5.68 / 2.06 = 2.75
We can express this as we are risking $1 for every $2.75 we expect to make. Does this fall into your personal trading system? Were you looking for 3 to 1 or 5 to 1, that will depend on how adept you are at picking a direction? We will look at a few more examples in next weeks blog to solidify this concept as this is extremely important to be a successful trader. Until then look at some stocks and do your math and see if they fit the bill, if not then move on to another trade as there is always more trades out there for smart traders.