There are several methods for the calculation of Stop Loss values in Trading. Such as setting stop loss based on a percentage of your account, based on Support and Resistance from chart, based on price volatility, and based on time limit. Out of these more sensible way of setting Stop Loss would be to base it on Support and Resistance from chart. Before going to that let us have a look in to the support and resistance level.
The support and resistance are particular price points on a chart. Support is the price level at which more chance is to increase the price than declining. At this level demand is strong such as can expect more number of buyers. Usually support levels lie below the current market price. But sometimes it becomes very difficult to establish the correct support level from the chart. Support as its name suggest prevent price from falling further. Sometimes, price movements can be volatile and may briefly dip below the support. If the price closes 1/8 below the established support it does not seem logical to consider a support level broken. This is the reason that some traders establish support zones.
Likewise, resistance level is the price level at which more chance is to decrease the price than increasing it. At the resistance level number of sellers is more than number of buyers. Unlike support level resistance level is always above the current market price. Resistance as its name suggest prevent the price from rising further. The support often acts as a trigger to buy similarly, resistance often acts as a trigger to sell. How to identify this support and resistance level is obviously the next question. The identification process is simple and same for both support and resistance.
There are four steps to construct the support and resistance levels. They are
1. Load data points
2. At least three price action zones identification
3. Alignment of the price action zones
4. Fit a horizontal line
In order to identify short term stop loss and resistance level load minimum 3-6 months data point. And to identify long term stop loss and target load minimum 12-18 months data points. Usually swing traders use long term support and resistance points. For day trading and BTST trading short term support and resistance level is used.
Identification of the three price action zones such as
• The zone at which after a brief up move the price hesitated to move up
• The zone at which after a brief down move the price hesitated to move down
• Sharp reversals zones at specific price point
The identification of same price action zones that are at the same price level. But it is very important to note that these price zones are well spaced in time. That is if the first price action zone is identified on second week on June, then it will be meaningful to identify the second price action zone at any point after 4th week on June. If the distance is more the S&R identification becomes more powerful.
Connect the three price action zones around the same price levels with a straight horizontal line. So we get a price value. By comparing this price value with the current market price it become either resistance or support point. The support and resistance points are only indicate possible price reversals. This cannot be considering as certain. Like other tools in technical analysis, one should balance the possibility of an event occurring in terms of probability.
For a successful technical analysis the identification of support and resistance is an essential key point. You may face some difficulties to track the correct support and resistance levels. However, better awareness about support and resistance locations and their existence can greatly boost your analysis and forecasting abilities. The breakout of a resistance level is a sign of increased selling pressure and potential reversal. The breaking of support and resistance level indicates that the relationship between supply and demand has been changed. Resistance breakout means demand has gained the upper hand similarly support breakout means supply (bears) has won the battle.
How to set stop loss based on support and resistance level?
Now let us discuss how you can calculate stop loss values based on the support and resistance level. Taking chart saying stop loss is a more sensible stop loss determination way. But you might always be aware about the market. While observing the market movements you can see different varieties of price actions. One is that price stick on some certain levels not push or break beyond from that level.
For a trader it is always better to place stop loss beyond support and resistance levels. Often think that a break of support and resistance area will bring large number of traders to play the break and further push your position against you. On the other hand if those levels do break, then there may be forces that you are unaware of sudden up/down movements of the market.
It seems that the market moves up and then you decided to go for a long trade. But before you go for a long trade ask the following questions to your mind
• Where I could set my stop loss?
• What conditions would tell me when my original trade idea is invalidated?
If you take a long call then set your stop loss below support area and trend line. In this case, if the market moves into these areas which implies your trade idea was invalidated. So exit the trade and accept the loss.
Similarly in the case of a short call set your stop loss above the resistance areas and trend line.
Example: Long Crude Oil
The Crude Oil has been trending up. Price has hit the rising trend line a couple times which makes for a nice support level. You could place a long order right at the downtrend line (3650). Now, where you would you place your stop loss? Your stop loss would be placed at 3620. Notice how this is below the support area: the rising trend line. Let’s set profit targets at 3665 and 3675. The trade is triggered. The trend line holds as support and price rise.
Your first profit target is hit. The second profit target is missed by a single point but by that time, you had moved your stop loss to breakeven (where you entered long) so you lost nothing. This is an example of using support as a guide on where to place your stop instead of simply using a fixed number.
A direct stop loss displayed software is always useful for a trader