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Identifying Stops And Targets By Jeffrey Kaprelian
How do you figure out where to place stops and targets? Try using support and resistance levels together with the average true range. As a broker, I am often asked how to figure out where to place stops and targets. There are, of course, many different methods, ranging from not using them at all to using volatility-based figures. One of the most reliable is the use of support and resistance coupled with the average true range (ATR). I will demonstrate this principle using multiple time frames with two unrelated markets to show how truly universal it can be.
First of all, we must define support and resistance. The most basic understanding of support is a level where prices fail to make new lows. The opposite — the failure to make new highs — is true for resistance. They can be thought of as floors and ceilings.
SUPPORT AS STOP-LOSS
Figure 1 is a weekly coffee chart. Once the market makes a double low (points 1 and 2), we can use that as a temporary level of support. Observe how the market retraces at points 3, 4, 5, and 6 before it moves away for good. Often, the exact level (56.234) at which the dotted line is drawn is inconsequential relative to any major price points — in this case, 56.000 — when setting a stop-loss.
FIGURE 1: WEEKLY COFFEE CHART. Here you see where the support level is. You can assume that trades at or around 56.000 will serve as entry and exit points in both directions.
There is no guarantee that stop orders will be filled at the trader’s preferred price. Once the stop order has been triggered, it turns into a market order, which is then filled at the best possible price. The fill price may be higher or lower than the price specified by the stop order.
The reason we move down to the next major number is because of a phenomenon known as “group think.” We can assume that most traders think alike and can identify support and resistance just as easily as the next guy. The difference, though, is that traders have different motivations for buying and selling and generally have strong and opposing convictions for the market’s direction. Therefore, you can assume that trades at or around 56.000 will serve as entry and exit points in both directions for many traders.
FIGURE 2: IDENTIFYING STOPS. Using the ATR along with support levels helps identify ideal stop-losses and entry prices.
So let’s backtrack to point 2 (Figure 2). Now that we’ve established support, we still need to figure out what to do with it. For our purposes here, it should act as a stop-loss for any long positions. This does not, however, give free rein for entry prices. It would be impractical to enter a trade at 70.000, for example, and still use 56.000 as a stop-loss. A better method would be to gauge an acceptable range of entry based on the ATR.
With the ATR plotted at the bottom, it gives us an idea of how far the market has been moving on average. In our example, when our support point has been identified and we should be thinking about a long position, the ATR is 4.04. We use this number to calculate the maximum price we’d be willing to pay for a long position:
Highest entry price = Support level + ATR
Similarly, for a short position:
Lowest entry price = Resistance level – ATR
For our coffee trade, the maximum entry price is 60.274 (56.234 + 4.04). Similarly, if the goal of this trade is to capture a longer trend, we can extend the stop-loss with the same method (56.234 – 4.04), giving us a maximum stop-loss of 52.194:
Stop-loss range for long positions = Support level – ATR
Stop-loss range for short positions = Resistance level + ATR
Therefore, the rules for this trade would have been (Figure 3):
Entry range: 56.234 to 60.274
Stop-loss: 56.234 to 52.194
FIGURE 3: ENTRY RANGE AND STOP-LOSS. Using support levels, resistance levels, and ATR, you can identify your entry zone and stop-loss.
The same rules hold true for the other retracements to support at levels 3, 4, 5, and 6. While the ATR is different, the mathematics and logic remain the same.
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IDENTIFYING TARGETS
Now that we’ve identified stop-loss levels and acceptable entry ranges, we can begin to search for exit points for our trades. Using the same techniques, we are able to find an exit zone. Figure 4 utilizes a 30-minute WTI crude oil chart. Next, we identify resistance where the market fails to make substantially higher highs. Once that is established, we can calculate our entry and stop-loss zones by adding and subtracting the ATR from our resistance level (100.75 +/- 0.31 = 101.06 to 100.44).
FIGURE 4: 30-MINUTE CHART OF WTI CRUDE OIL. The entry and stop-loss zones are identified by adding and subtracting the ATR from the resistance level.
We can also identify a swing low on this chart of 98.48 (Figure 5). Using the same zone principle, we find the target zone based on that swing low to be 98.90 to 98.06, given the ATR of 0.42 upon price reentering the entry zone. From this we can derive our risk–reward ratio for this particular trade, using the worst-case scenario.
FIGURE 5: IDENTIFYING TARGETS. Using the same zone principle, you can find the target zone based on that swing low.
For a short position, the worst-case loss would be the top of the entry zone (101.06) minus the lowest point of the entry zone (100.44). The minimum profit target is the top of the target zone (98.90). Therefore:
Maximum loss: 101.06 – 100.44 = 0.62 ($620 in crude)
Minimum gain: 100.44 – 98.90 = 1.54 ($1,540)
Profit to loss ratio: 2.48:1 (that is, minimum gain is 2.48 times greater than the maximum loss)
Note this example does not include slippage or transaction costs. If you prefer to wait for support to establish itself rather than using a swing low to calculate a target, this particular trade replicated itself in the coming days (Figure 6). Upon reentry of the zone, we found the ATR at 0.39. This gave us a new target zone (98.48 +/- 0.39 = 98.87 to 98.09).
FIGURE 6: USING SUPPORT TO CALCULATE TARGETS. Instead of using swing lows, you can use support to establish itself. The ATR at reentry was 0.39, giving you a new target zone of 98.87 – 98.09.
CONCLUSION
Charting is as much art as it is science. Support and resistance work so well for trading because in the short term, prices are “sticky” — that is, while prices may move around to various points, they tend to return to certain levels. Keep that in mind as you plan your trade.
Jeffrey Kaprelian is a futures broker with Infinity Futures. He is a member of the National Futures Association and registered with the Commodity Futures Trading Commission.
