As for the stop, how much room above the 61.8% level should you give your position? I will often look for a chart point above the 61.8% resistance level.
Alternatively, one can use a stop 0.5% above the 61.8% resistance level, which would put the stop at $144.81 + ($144.81*0.005) = $145.54. This would make the risk at $145.54 - $142.88 = $2.65. Instead, if one sold at $142.37, the risk would have been $3.17.
Now, what are the likely downside targets? The most conservative target would be a test of the low at $126, but I generally look for a move to the 127.2% retracement level, calculated using the rally from point 2 to point 4. This level was $120.88.
Using either target level, the risk-reward was clearly favorable. The risk was at 2.65 or 3.17, and the reward if the lows were tested would be 143.88 -126 = 17.88. So the trade would be risking 2.65 or 3.17 for the potential to make 17.88. Of course, looking at the 127.2% target, the reward was significantly greater.
On the other hand, you could wait for the close below the uptrend (line c) that occurred May 20. The opening on the following day was $139.43, and a stop 0.5% above the prior high would have been roughly $145.12.
This would have meant a risk of $5.69. But with the potential to make $17.88, the risk reward was still favorable.
The 127.2% target was exceeded on July 14, and then SPY began a six-week rebound.
Now let’s look at a bull flag example. This chart of the SPDR Gold Trust (GLD) covers the action in GLD from August through December 2007. GLD had just rallied 31.7%, from the low of $63.47 in August to a high of $83.64 in November.
In just seven days, GLD dropped to a low of $76.11 (point 3) and reached the 38.2% support of the rally from point 1 to point 2. Most traders, after missing a sharp rally, are too eager to get back in and buy on the first bounce.
The problem with this is, as often happens in a flag formation, the second decline will result in lower lows. Therefore, stops just under the first low will get hit, leaving traders on the sidelines at a level that in hindsight will turn out to be an excellent entry point.
In this example, GLD managed to rally back above the $82 level and filled the prior gap before the rally stalled. On the following decline, the low in GLD was at $76.98, which was well above the prior low.
After this low, a triangle formation was clearly evident (lines a and b). In my experience with this type of triangle, a break below the lows at point 3 would be quite unlikely.
Therefore, the strategy was to either buy on a setback towards the trend line support or the closing support in the $78.20 area. The initial upside target was the 127.2% target at $85.75, which was calculated using the decline from point 2 to point 3.
GLD traded as low as $77.80 in mid-December, before it again turned higher. A tight stop at 0.5% under the point 3 low at $75.72 could have been used; or, alternatively, a much wider stop under the 50% support at $73.50.
In the first example, the risk would be $78.20 - $75.72 = $2.48, while the risk on the wider stop would have been $4.70. The potential reward would have been $85.75 - $78.20 = $7.55. This would have made the risk-reward good with the tight stop but less than 2:1 using the wider stop.
Of course, this is based on the first target of $85.75—but the explosive nature of the prior rally made higher targets very likely. The 127.2% and 161.8% targets were hit within a month of the triangle’s completion.