Simple Manual Trading System Part 3 - Setting SL and TP
This article is the third part in a series of lessons aimed at beginners who have an interest in creating their own strategy.
How to set SL and TP in a simple manual trading system
Where to set your limits and stops is an important question that most beginners do not understand. SL and TP are essential values of an every trading system and that is why we will devote some time to them.
There are many ways to determine SL and TP size. All of them divide into related and unrelated with the market. IfI would leave it like this, which type of SL would you pick? Probably most of you, if not everyone, would pick market related SL. However I find pretty often essays, system threads, journal threads, etc. where people use fixed SL no matter what. If they trade on Monday or Friday, Cable or Aussie, they use fixed SL. "It works for my system" - they say. What they do not tell, is that probably this system contains 10 or 20 trades in its history sometimes on a single instrument. How do they know the exact value of their fixed SL stays unclear. Maybe it's just guess. But if we take under consideration the actual state of the market, and, i.e., same market 10 months ago, we will probably find out, that now we have to deal with different volatility, and maybe different sentiment. How does fixed SL fit these both situations? Assuming that system is good enough to stay in use for 10 months. Same problem comes with fixed TP. If we wish to earn money on the market, we need to have bigger TP than SL. Perhaps the bigger the better. Unfortunately, it won't do any good. Theoretically the best is to have 1 pips SL and 100 pips TP or so. But here intuition tells us, that our SL cannot be too little, because we'll be wiped out from almost every trade. Similar with TP, that should not be too big, otherwise we limit our chance to score it. On the other hand to big SL will make us risking too much and too little TP will make trading not worth it. Let's go forward then.
After crashing rationale behind fixed TP and SL values, let's look closer to different ways of pointing SL and TP on a living market. Monday, Wednesday and Friday are barely similar and so is volume or volatility. Therefore many traders approach to the problem referring somehow price movement range.
The simplest method, in my opinion, is to set SL right below our signal candle, formation, pattern, etc. Because trading systems using such signals base on the assumption, that these signals points to some change in order flow that will push price into predefined direction. If you trade intraday, you may pick session open, pivot point or previous day high/low as these levels are very fragile to the sentiment shifts. If price breaks session open then probably most investors would like to build profits in the new direction. And when price beats previous day high there are more profits on everyone's sight. Therefore trading from open to high or from high to low have its grounds in traders collective behavior.
Other people use S/R levels, Pivot levels, packs of candles that tend to point supply/demand areas, or other stuff. All these methods have in common using some price characteristics that will tell you where your trade will become invalid.
The other way to pick SL level is by using indicators. Most common is Average True Range (ATR) which measure range from n periods averaging it down. This will provide you some good insight into not what but how rapidly price was doing. Assuming, that your system will tell you the direction, ATR should tell you what profit to expect, and what loss you need to withstand. And remember, you don't need to resist the price momentum. Actually strong move should hit your Stoploss preventing you from losing more on sentiment reversal. Your SL should mainly resist the corrective move and corrective move only. Therefore you don't have to pick the highest value. Very often used proportion is 50%-70% of highest value in certain time. That's right! If you trade intraday during the great overlap, don't use ATR from night hours because you can harm your account.
On the above M15 EUR/GBP chart we've picked ATR with period "1" (green) and "4" (red) taking most common tops as our Stoploss. Notice, that average from longer timeframe will be smoothed therefore it might need some further adjustment. I have put these values on chart but how would I know if they are really the proper ones? Candles fit pretty well. Then I placed Bollinger Bands and pivots too, to check how these correlate with my SL. This is the other valid idea to use bands like Bollinger or Envelopes. These indicators also base somehow on price volatility. You can pick the further ribbon of bands as your last post and most likely it will hold the price until sentiment changes. Please check first on demo account if it fits your system and what band values would be proper for your trading. Nevertheless, if you trade with momentum you may find them definitely worth trying.
It turned out, that I sold a pivot point with Stop Loss levels well above the upper band of Bollinger Bands channel. Trade seem to have good foundations.
And there, trade went on.
Here is the other example of our SL set. It is good, because we've missed the buy order totally but still look how well our ATR-BB-based Stop Loss is doing.
How to handle the Take Profit? It's often good to find a strong support/resistance on our way - ideally if it's far enough for us to get 2:1 or 3:1 Risk Reward. Such target could be next pivot level, yesterday's high/low or maybe recent week's high. If we trade with trend, or intraday prevailing direction, it's ok to assume, that first support/resistance will be broken and the second one could be our main target.
To finish this up, we can book our profit of $230 on pivot resistance.
And for our books to be clear we need to subtract $180 from EUR/USD loss. And we have still something left.