In our previous two articles on chart patterns (Part 1, Part 2), we reached the point where we know what the main types of chart patterns are, how to identify and validate them, while we also placed them in the context of trend and cycle analysis and used them to start constructing a comprehensive trading plan as well.
You might say that the last two steps of a trading plan, which we will cover in this post, are the most boring ones, but in practice, these are sometimes way more important than the rest, and they can determine how successful your plan, and in general your trading will be.
Setting Price Targets and Stop Losses
Simple Pattern (Trading Range) Based Stop in a Trend Following Trade
Chart patterns in themselves are very helpful in setting both price targets and stop losses as they provide support and resistance levels as well as range projections in both directions. You can find a detailed look at support and resistance levels in this article and we took a look at range projections before too. So the “natural” set of targets and projections are support and resistance levels, and pattern or range projections.
Target Determined by Range Projection Hit
Another useful and popular way of setting targets is using different Fibonacci-type (retracements, extensions, arcs…) indicators, which are based on the evolution of dynamic natural patterns. We will devote a series of articles in the coming weeks for the “Fibo” universe, for now, remember that the basic concept of targets and stop losses is the same, no matter where the exact level comes from.
A Triangle Based Long Setup Hits its Target
A Closer Look at Range Projection Targets
On a side note, the idea behind range projections is the fact that a given market has a certain set of properties that define the volatility and the “normal” moves in a time period. This phenomenon is the consequence of several different things, like the more or less stable players that trade the market, the memory of these players, and the “memory” of all the indicators, automatic trading strategies and other tools that support traders and investors.
Extended Break-Out after Long-Term Compression
That said, in practice, there are some reservations regarding range projections, in the case of long-term consolidation patterns to be precise. In a lot of cases, trading ranges “outlive” their normal life cycles, as sideways markets tend to scare short-term traders away, leaving volumes low and the market unchanged for a longer period. In these cases, the range projection (in either direction) usually turns out to be a very small move compared to the “tension” that builds up during a consolidation, so more ambitious targets might be in order.
Illiquid Markets, Profit Targets and Stop-Losses
Markets with low volumes provide both Problems and opportunities for traders. The problems usually arise concerning stop-losses while you can catch great trades on the side of profit taking. “Stop-hunting” is much easier in illiquid markets where the breaking of a meaningful support/resistance level could lead to an outsized move, with the order book being close to empty, even a little further away from the current price.
Stop Hunting Spikes in a Strong but Illiquid Uptrend
When trading illiquid markets, using automatic stops could be really frustrating if you don’t set-up a rule (or those rules are not available) for the order to be triggered when the price remains outside the stop for a certain amount of time (and thus ignoring brief spikes).On the other hand using automatic profit taking orders seemingly way above/below certain important levels could boost your trading results substantially.
Example of Using Spikes to Your Advantage with “Fishing” Order
Those are also true when trading based on patterns, while liquidity is also having an effect on the entry points, not just the exits. When dealing with illiquid assets, taking on new positions while inside a correction/consolidation pattern makes a lot of sense, as a break-out might be more violent and an automatic order might be realized much further away from the break-out point, or you simply miss a large part of the move when trying to enter manually.
Stop-Losses Should Determine the Size of Your Positions
You might wonder why we haven’t spoken about the size of the position yet, although we already have our target and stop loss levels. That’s because the size of the position should be an automatic function of your money-management strategy and the trade set-up, namely the “distance” of your stop loss level from your entry point.
We will spend a lot of time with different money-management approaches that are suitable for different trading styles, but for now, we will use a very common rule, the max 2% risk rule. A lot of individual traders use this (or the 1%, 3%…) rule when entering new positions. The method is simple; you only risk a maximum of 2% of your full portfolio on one position. That means that if you place a stop loss order 2% from the current level, then you can take on a full position in that trade (meaning a leverage of 1 not the maximum leverage that might be several hundred times your portfolio), while if you place a stop 10% from the entry point, you are only allowed to put 20% of your portfolio in that trade.
Approaching position sizes from the “side” of the amount of your risked capital is the final piece of the pattern-trading puzzle. This way you will have a very powerful trading method that can be used in all types and all sizes of markets, while also being helpful in determining entry points for value investment strategies.