Effectively Stopping CONTINUATION SETUPS
Frank R. Bunn
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The consistent Continuation Setup trader has two key responsibilities: (1) identify and exit breakout failures quickly with minimal loss; and (2) maintain positions in breakouts which are behaving properly. Done effectively this practice can yield massive profit ratios. However, the pursuit presents a curious dichotomy: the very impatience necessary to immediately eliminate risk is the deadly enemy of exceptionally large profit. Why? Because strong momentum stocks will encounter numerous bouts of selling on the way higher. It's like that Kenny Rogers tune - you've got to know when to hold 'em and know when to fold 'em. The purpose of this segment is to present a specific stop strategy for momentum trades which focuses on risk control. A side-effect will be the virtual elimination of the above mentioned dichotomy. Although I teach risk shedding to novice traders, I don't employ the practice myself. I would rather own the entire position for the bulk of the move. There is nothing wrong with the risk shed given high probability follow through, but it can yield an inverted size dilemma whereby the largest position is held inside the risk window and a diminished position when risk has been eliminated. Bear in mind that the trader cannot have the proverbial cake and eat it too. To wit, you will not be able to withstand constructive adverse price movement AND sell into strength. The purpose here is to still be long after 20, 30 or even 50% appreciation. Let's review a recent Continuation Setup before identifying our stop tools:
There are two (2) stops we will employ to achieve the objective: •
INTERVAL LOW STOPS
•
FIBONACCI RETRACEMENT STOPS
Let's define each one before proceeding: INTERVAL LOW STOPS This stop uses the lowest price on the interval in question as the trailing stop. Simply place the stop 0.01 or 0.02 below this low. LOW STOPS WILL BE PLACED ON EACH BAR WHICH BREAKS OUT OR ATTEMPTS TO BREAK OUT OVER A SIGNIFICANT RESISTANCE LEVEL. Low stops can also be used early in the trade prior to follow through breakout. FIBONACCI RETRACEMENT STOPS This stop employs the 0.618 retracement level as the basis for the trailing stop. It is used on interval bars in which the range clearly EXCEEDS the average interval range. Again, the actual stop is placed 0.01 or 0.02 below this level. Let's return to LOEWS CORP and see how I managed this trade:
At the outset, L offers a very low risk entry around 2.25%. In the first interval, price attempts to breakout over level A but fails. This qualifies the trade for an INTERVAL LOW STOP on the entry bar. The stop is moved 0.01 below point C. Notice how the risk has been effectively reduced by almost 50%. This action can be seen in the following chart:
Let's see how the trade progresses with the next chart:
The second interval bar breaks out over levels 1 and 2. This qualifies the trade for an INTERVAL LOW STOP on the second bar of the trade. The stop is moved 0.01 below point D. Notice that the initial risk has been reduced by over 80%. Let's see how the trade continues to unfold:
Whereas the second interval of the trade exhibits a range of twice the average interval range, the trade qualifies for a FIBONACCI RETRACEMENT STOP. This is calculated using the high and low of the interval in question - in this case the bar immediately following the entry bar. A stop is place 0.01 below point E. Risk has theoretically been eliminated. Remember there are only three (3) ways to eliminate risk: 1) offset the position; 2) price rejection; and 3) stop placement. This strategy employs numbers 2 and 3. Even mild price momentum (rejection) will produce opportunities to move stops. Here is the key: once the trader enjoys follow through (either a significant new high OR resistance/support level), price must remain on the proper side of the breakout. The trader needs to determine the point at which a breakout failure places the trade in jeopardy. INTERVAL LOW STOPS and FIBONACCI RETRACEMENT STOPS are a great way to objectively do this. Systematic risk elimination or reduction is the focus UNTIL (if and when) the breakout occurs. The general idea is to never really take a loss equal to the initial maximum risk. Considered as such, you can see how your profit ratio will be greatly elevated.
If you target 2 or 3 or 4XRISK for exits, but seldom take the maximum risk loss, the profit factor is skewed even further in your favor. Let's take a look at a loss:
The purpose of my effort is to relegate losing trades to somewhere in the neighborhood of 1% or so. Then I want to let my winners run. Let's check one out:
Notice that in the first bar of the trade I was able to theoretically eliminate risk. It's very common for Continuation Setups to go 10% or so. Much less common are the 50% or 100% moves. Frequently the latter depend on exceptionally strong broad market trends. However, if you confine your breakout failures to 1-2% loses instead of the 5-8% maximum risks enjoyed by most systems, you can turn small winners into a larger profit factor. Give it a try. You should find yourself Effectively Stopping Continuation Breakouts...just as advertised.
