What is a stop-loss?
A stop-loss is an essential part of a trader’s strategy. It is the price point at which the trader has decided in advance to get out of the trade, should it not work as anticipated.
This price point is often a miscalculated parameter. Some traders, who manage not to follow any disciplined method of trade execution, actually use their maximum pain tolerance point as a stop-loss point. This is the point beyond which they absolutely cannot bear the pain of owning the stock.
The most common recommendation for setting stop loss points is a fixed percentage. Traders will define a stop-loss point as say 3% below their buy point. Some will define it as 2% and some as high as 5%. Though this method does not have any inherent logic to it, at least it gets them out of the falling stock. This frees up the capital and allows them to use it for other investments.
Traders following candlestick charting are at a distinct advantage here. They realize that the stop-loss point is a function of the candlestick buy or sell signal itself. The percentage below or above the buy / sell point has no meaning for these traders. Once a high probability profit scenario is found and a buy point defined, the obvious question to ask is – at what point does the buy signal get negated? That is the point for a stop-loss limit.
If one observes a Hammer signal in oversold conditions and buys on confirmation, then what would be the stop-loss point? It is already analyzed that the bulls should have taken over the trend from here on. If the bears can manage to take control and bring the stock all the way back through the bottom of the Hammer, then is the Hammer signal still valid? No. The signal has failed. Selling the position now for a small loss makes perfect sense and above that, gives your trading a methodology. Remember, you can always get back in the stock if another buy signal is witnessed. But at that point in time, it is advisable to get out as the probabilities are no longer in your favor.
Consider the following chart of ALKS. The Point A is an extremely good entry point. The day before witnessed a Bullish Harami, which was also an Inverted Hammer. The stochastics were oversold. The proper procedure was to get in on the confirmed signal. However, this was one of those times when the signals failed as one can notice. The trader who bought in at Point A, should have set his stop loss at Point B. This point is the bottom of the Inverted Hammer. If the bears managed to drag prices through that point and close below it, there was no need to be in that position anymore. The probabilities were no longer in the trader's favor and the proper strategy would have been to get out. Remember, one can always buy back on the next buy signal.
Stop loss procedures for candlestick signals are taught in detail in our Basic Candlestick Course.
Chart courtesy stockcharts.com