Saturday, September 02, 2017

An example in trade management - the breakout stop

A few days back, I posted here about the potential long set up on Gold that was forming. Lo and behold, later that day price broke out.

Once you are in a trade, the next stage to consider is the ongoing trade management and the use of stops. So we will look at the updated gold chart (shown below) to see how I do this.

A key change I made a few years back was to introduce a 'breakout stop'. This idea I got from reading David Ryan's interview in the original Market Wizards, which I took and modified to suit my own requirements. 

This is different to where I place my initial stop - that is calculated using a multiple of average true range, and at a level somewhat further away on the chart.

Basically, my reason to enter a new long position is a price breakout to new highs. Should price fall back into the 'pre-breakout consolidation zone' then the reason for entering the trade is no longer valid. The breakout has failed - so therefore the trade has not worked. To me, that is a signal to exit the trade, even though price may be nowhere near the initial stop price level.

We can see on the gold chart how price broke out aggressively at the beginning of this week, before falling back to the breakout area, where the potential new uptrend re-asserted itself.

To me, the best trades are those where price breaks out and never looks back. Occasionally however, you get a retest of the breakout area before the new move continues. 

You can view this as the breakout level on a long set up being a resistance level that needs to be broken. Where price then falls back to that same area, a rebound back in the direction of the breakout is a successful example of prior resistance now acting as support

It is important to build in some slack about exactly where you determine to place the breakout stop. You should view these levels not as an exact price level, but an area or zone where there may be buying and selling.

Look again at the chart. I have zoomed in to show the last few months activity. You can clearly see the prior highs made in April and early June, the intra-day high in mid-August, and the intra-day low on Thursday this week - they are not at exactly the same price level, but all are pretty close to one another.

You can try and formularise this in a number of ways. You can factor in the typical spread (this can be useful on stocks), introduce the 'breakout stop' after a certain period of time of being in the trade, or place the breakout stop at the low of the breakout days' candle. Other people I know wait for a price close below the breakout level before exiting, or use a set percentage of the initial price distance between entry and the initial stop placement. 

It is a bit of an inexact science in that, every so often, you can get whipsawed around at these levels as there is a battle between buyers and sellers. But I always view that as a cost of doing business.

What I want to avoid at all costs is buying a long breakout, seeing the reason for entering the trade (the breakout) fail, but I hold on and refuse to take a small loss, only to see price continue to drop, thereby increasing my loss. 

I suffered plenty from this in the last quarter of 2011 in particular (which was particularly volatile), and led me to introduce the breakout stop in 2012. 

Once the breakout stop is in place, that will remain until such point the trailing stop (a 10 day low) overtakes that price level. And then that will be updated as required, based on future price movements and the calculation of that price level (shown as the thin red price line on the chart). 

One final important point - the breakout stop is not the same as a breakeven stop. My entry price will always be slightly higher than the breakout level, and my stop level will always be slightly below the breakout level. This would be as a result of any price spread I have to deal with, potentially some slippage etc. So if a breakout fails, I will never get out without at least a small loss.

This is borne out by the list of past trades, where you will see the majority of losses suffered are significantly smaller than -1R, and the trade is held for a short period of time. These are examples of trades where the price breakout quickly failed.

So now, there is nothing to do other than update the trailing stop once it becomes active, and that alone will tell me when the trade is over.

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