Question of the Week: 7/9/2008
When you set your stop loss, what do you consider most important?
Once you enter a market, the stop-loss level you choose is the most critical step (and for many, the most difficult) in the trading process. It will decide whether you get stopped out too early, whether you are risking too much of your capital on a single trade and whether you give back too much of your profits following a good run.
I searched for the answer to this question for over 20 years and finally began to arrive at some conclusions within the last 5 years, which has evolved into my NEELY RIVER trading technology. The only way you can place orders at the correct point in an uptrend or downtrend is to understand which group is "in charge" of that trend. How do you do that? According to Neely River theory, there are only three ways to trade an uptrend and three ways to trade a downtrend, no matter who you are and no matter what system or philosophy you favor.
IF YOU BELIEVE THE MARKET IS IN AN UPTREND
1. You can attempt to pick the top, which requires you sell into new highs.
2. You can be a trend follower, which means you are buying into new highs.
3. The last way you can trade an uptrend is by buying market pull-backs AFTER a suspected low has occurred (somewhere in the 33-66% retracement area).
IF YOU BELIEVE THE MARKET IS IN AN DOWNTREND
1. You can attempt to pick the bottom, which requires you buy into new lows.
2. You can be a trend follower, which means you are selling into new lows.
3. The last way you can trade a downtrend is by selling market pull-backs AFTER a suspected high has occurred (somewhere in the 33-66% retracement area).
If a market is actually in an uptrend, all (or nearly all) those who are trading as if it is in a downtrend will lose money (so at least 50% will be wrong from the start). Next, of those in the bullish crowd, depending on the character of the uptrend (chaotic, drifting or trending), the manner in which you enter the market, place stops and exit will determine whether you make or lose money. In any uptrend, it is extremely rare for all three trading styles to do well. The market will almost always test the trading strategy and stop placement of at least 1/3 of the bullish crowd. Frequently it will test 2/3's, which leaves only 1/3 of 1/2 (i.e., 1/6 or just 12.5%) of all traders actually making money in an uptrend (no wonder trading is so hard).
To trade successfully, you need to trade in a manner consistent with that 12.5% group who is on the right side of the market and placing stops in the correct manner. How do you do that? Study the way each group places stops and make sure your stop placement strategy is consistent with those "in charge" (or in sync) with the current rhythm of the market. The way that is accomplished is what NEELY RIVER theory is all about and what I teach in my private, one-on-one trading classes.
Click here to view NEoWave's Question Of The Week archive