LIMITING THE RISK OF A TRADE

A stop-loss works when you are using basic charting techniques to identify support and resistance lines. Stops can be used very effectively. There is an orderly process in deciding on how to apply a stop-loss, or whether to apply one for a specific trade.
Consider whether the natural buy and sell signals for your trading method provide adequate risk control. When the trade goes against your long position, does the system create a sell signal that gets you out with an acceptable loss? For example, you wanted to trade Amazon using a 200-day moving average, but when prices reached $90, the moving average was still lagging at $40. It finally turned down when prices broke below $50, capturing only onehalf of the profits. What could you have done?
1. Place a fixed dollar stop, the amount you can afford to lose.
2. Pick a support level on the chart that would signal a change of direction.
3. Draw your own trendline that would signal a change of direction.
4. Move the stop closer as profits accumulate in order to lose only a fixed amount of your peak profits.
All of these approaches have been used by traders, but not all of them are good solutions. The most important rules to remember are:

1. The best place to exit from a long position is the natural point where you would want to enter a short position.
2. The size of the stop-loss must be related to the speed of the trend. If you are trading a slow trend, then the stop must be farther away.
3. The stop should adjust to the volatility of the market. Your stop can be closer if the price changes are small or the market is quiet, and larger if prices are volatile.
4. A stop-loss must not be closer than 11⁄2 times the current volatility (the high to low range). If you want it closer, you should simply close out the trade.
5. You must first decide how you would reenter the trade once you are out.