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Setting Profit Targets and Stop Loss Orders

2-1-2004

Question:

Can you suggest how I should set profit targets and stop loss orders on a trade?

Answer:

Wow, this is a big question! In fact, you could write an entire book dealing with setting profit objectives and stop losses. Let me give you a few guidelines to follow that might help you out.

First, setting profit objectives. Being a support and resistance technician I am always looking for support or resistance areas that are likely to reverse the market. If you are trading a reversing market, one that seems to be retracing part of a previous move, the easiest way to set a target is to use Fibonacci ratios (38, 50 and 62%).

The market will have a tendency to move towards these areas before reacting. By concentrating on significant support or resistance near these retracement areas, I can narrow down my search for prices that are likely to affect the market.

If you are trading a trending market, then you will have to look back in the history of the chart, sometimes consulting a longer term weekly or monthly chart, to find areas of support or resistance that look like they might affect the market.

If the long term chart is also retracing a previous move, you can once again use Fibonacci ratios to give you an idea as to where prices are heading. Keep in mind however, that the longer term charts will take longer to reach their objectives than the daily chart.

When choosing a stop loss, I will again focus on using support and resistance to help me find suitable areas to limit my risk. In a trending market, the best place to trail a stop loss is beyond the pullback areas that develop as the market trends. These are significant as they are proven areas of support or resistance. Unfortunately, the pullback moves can sometimes be quite large, and leave too much money at risk.

Therefore we sometimes need to find closer support or resistance lines to use as stop losses. Occasionally, the high (or low) of the day will form a good stop loss area, especially if it coincides with other support or resistance. This is usually the least amount of money you will be able to risk on a trade, without having to increase the riskiness of the trade by placing exit stops within the daily range.

If you do need to enter the daily range, in order to minimize the risk enough to make the trade worthwhile, consider placing your exit order beyond the closing price. The closing price will often form a support/resistance area as the market winds down, so this can be an alternative; however be aware that placing your exit order within the market’s daily range does make you more susceptible to whipsaws.

-Erich

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