How to Place Better Stops with Candlesticks
11/09/2012 9:00 am EST
Traders are right more than 50% of the time, but lose more money on losing trades than they win on winning trades, which is why Tyler Yell, of DailyFX.com emphasizes the importance of setting the proper stops.
When a trader moves from looking at a strategy that will rain money to identifying strategies that will help him minimize risk, he’s on the right track to long-term successful trading.
You may be familiar with DailyFX’s exhaustive findings on the number one mistake forex traders make over time. If you haven’t had the pleasure of knowing what we found, here was our summary:
Traders are right more than 50% of the time, but lose more money on losing trades than they win on winning trades. Traders should use stops and limits to enforce a risk/reward ratio of 1:1 or higher.
This tells you that a strategy to optimize trade exits appropriately will be based on stop and limit placement. However, if your stop has no respect to the market dynamics you can see price go back to your stop from your entry without negating the overall trend. This is definitely something to avoid.
One of the best ways to analyze market dynamics in real time is through effective candlestick analysis.
Candlestick Analysis will help you to know when the buying momentum or uptrend is outdone and the path of least resistance has likely flipped to the downside. You will also see this in real time so you can make adjustments to your stops as the market adjusts.
Proper stop and limit placement will help you avoid the two-step forward and three-steps back trading trap that many new traders find themselves in.
How Should You Look to Candlesticks for Placing Stops?
With candlesticks, you can identify a potential exit where market sentiment has moved against your trade in real time, so you avoid a larger than necessary potential loss through common patterns.
Candlesticks patterns have been developed over the centuries by rice farmers in Japan and are well respected because of their ability to stand the test of time and help you see real time sentiment towards price.
It is advised that when sentiment has shifted you should exit your trade. By exiting when sentiment has shifted, you will be freeing up the funds that were tied to a poor opportunity and give yourself the ability to work on a newly identified trade that can improve your month-end results.
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This Japanese Proverb is often quoted by candlestick charting enthusiasts, “Candles exhaust themselves to give light to men.”
Keep this in mind to know that studying candlestick patterns on the chart will give you better insight on important market levels.
There are multiple candlestick patterns that can help you see when sentiment has shifted against your trade so that you should be looking to exit that trade. Learning the patterns will allow you to place a stop that respects market dynamics. Once you grasp the basic patterns, you can adjust your trade size to ensure a small percent of your capital is risked on a per trade basis.
Now that we know why we want to do this, here is a recap of what will affect where your stop is placed:
Adjusting trade size will give you more or less flexibility in placing your stop in respect to the market.
Technical analysis of price action that clearly shows you the real sentiment of the trading day by showing the open and close in relation to the high and low.
Confirm the market environment with overbought/oversold tools or identifying top/bottoms that are forming when analyzing candle formations for stop placement. Seasoned candlestick users focus on candle patterns when candles are touching a major moving average or a complementary indicator like RSI, Bollinger Bands, or Stochastic shows them a signal to confirm what the candles are telling them. This way, you’re clarifying what’s happening in the market before you use this very good tool.
Notice: This pair is in an uptrend. If I’m placing stops on a buy trade, I’m only interested in candles where the higher-lows are tested. Therefore, I’m looking for two things in an uptrend (opposite applies in downtrend):
- Strong bullish reversals with follow through when the market is oversold as confirmed by oscillators or market extreme indicators like Bollinger Bands.
- Continuation signals that show market sentiment moving up continually so that I can trail my stop as the trade develops.
You can also use common moving averages like the 50, 100, and 200 work well for seeing how price is reacting around important price points. When you see a candle completely formed after the close
Range Bound Current Market Example – GBP/USD
In summary, we will look to candlestick reversal or continuation patterns to place our stops. When you manage your stops based on real time market sentiment you will maintain a good risk management plan based on market dynamics.
By Tyler Yell, Trading Instructor, DailyFX.com