Effective Stop Loss Procedures Using Candlestick Signals
Most investment "professionals" advise to cut your losses short and let your profits run. The biggest problem with that advice is the professionals never tell you “how” to do it!
Fortunately, candlestick analysis makes this process very easy. Simple logic dictates that if a candlestick buy signal is formed, it carries specific price expectations that form continuation signals.
Should the expected signals ‘not' develop, it is clear the trade has a lower probability of working. The trade should be immediately closed. No guesswork involved!
Japanese Rice traders developed a very simple logic/strategy for placing effective stop loss orders. If a candlestick buy signal reveals the Bulls are taking control, then the bears should not be able to close the price back down through the halfway point of the bullish signal. If the bears were capable of closing more than halfway down the bullish signal, that would indicate the bears are still in control of the trend.
As illustrated in the US dollar chart, a Bullish Harami is a signal that illustrates the selling had stopped. Bullish confirmation of a trend reversal requires positive trading the next day. Notice the following day closing back below the halfway point of the confirmation candle. This immediately revealed that the Bulls were not in control.
The mental state of an investor is important to successful investing. Profitable investing requires discipline! Every investor should utilize an investment program. The obvious reason is that investing investing willy-nilly without any guidance or course is foolish. The biggest downfall for most investors is their own emotions, and the candlestick signals provide a very simple and easy-to-use investment platform. The investment rationale that is incorporated into the candlestick signals provide insights into investment sentiment that is not found in any other trading method.
Having the ability to identify reversal signals creates an extremely beneficial dynamic for investors. Once an investor becomes comfortable that the signals represent a high-probability situation, investment trading rules can be better implemented. The elimination of emotions, especially fear and greed, should be the prime goal for investors.
The proper stop loss technique involves identifying the price level that negates the signals. The signals were created by a change of investor sentiment. A bullish candlestick signal has facets that we can visually identify. A‘buy' signal involves the graphic depiction of when and where bullish sentiment was taking control of a trend.
A critical factor for successful stop losses is identifying a level that would negate the bullish signal. This has nothing to do with a pre-established percentage loss. A proper stop loss level for one trade may be a 1% loss whereas the proper stop loss level of another trade could be a 12% loss. The variation in the percent losses has to do with the magnitude of the bullish signal. The advantage of candlestick analysis is the easy visual identification of a price level that would make a good trade potential not a good trade.
The first question an investor should ask themselves after they've analyzed a good bullish signal is, "What level would prices have to move back down to negate what the bullish signal was revealing?" This can be done much quicker and easier than when calculating where a 6% loss would be after your purchase.
A predetermined percentage loss may have nothing to do with the volatility of a price. For example, if trading the E-mini's or soybeans on a one minute chart, a 6% loss or even a 1% loss may have devastating ramifications for the trade and the account. Candlestick analysis has the benefit of telling us when to be in a trade and the logical level to be back out of that trade.
Successful stop-loss processes are very important in commodity trading or any fast-moving trading entities. This refers back to the volatility. Candlestick signals produce a high probability of being correct. Each person's definition of high probability can be different. The adage, in the commodity trading area, is that if you can be correct 55% of the time in your commodity trades, you will make a fortune.
Twenty years of utilizing candlestick signals has produced an unofficial correct trade ratio of 65 to 70%. The important qualifying word in this past sentence is "unofficial." With it assumed that candlestick analysis produces results somewhere above the 50% correct trade ratio level, stop losses have a very important function.
The preservation of capital is the first criteria. Even if the correct trade ratio was 90%, that would mean that 10% of the trades were unsuccessful. If an unsuccessful trade is not controlled properly, producing profits in an account becomes an extreme uphill battle. The difficulty for producing profits becomes compounded if the correct trade ratio is 55%, 60%, or even as high as 70%. If losing trades occur 30%, 40%, or even 45% of the time, stop losses become an integral part of any trading program. Establishing a trade, using candlestick analysis, merely puts the investor in a favorable probability situation. Always keep in mind, the term "probability" implies favorable results but leaves room for the possibility of unfavorable results. The purpose of the stop-loss is to minimize the possibility of prices moving severely in the wrong direction.
Taking small losses is like taking a bad-tasting medicine. You may not like what is happening right now but you will sure be happy in a little bit when the results are tallied. Taking a $300 loss two minutes after you establish a trade is much better than trying to figure out what to do if your position is now down $2000.
Many investors become mentally debilitated when caught in a big loss. The investment thought process becomes completely skewed. If a $300 loss had been taken, that leaves the mind clear for what the next trade should be. The mind is clear to search for the next high probability profitable trade? The money is sitting available ready to be placed someplace else. The mind is clear. It is looking for chart patterns and signals that have a high probability of producing the next trade profit.
Sitting in a $2000 loss position narrows the vision of what to do next. The predominant thought process is, "What do I do with the position now to recoup some of my losses?" That may not be the best place to have money sitting at that juncture. However, most investors want to beat the trading entity. They have just lost money in their soybean/gold/dollar/cattle trade and they want it back. As this scenario illustrates, being in a trade that was not stopped out at the proper place produces a completely different investment strategy. Unfortunately, that strategy is usually not the correct one.
The common sense attributes of candlestick analysis allow for cutting the losses short and letting the profits run. Simple candlestick rules allows an investor to maintain an investment discipline. The probabilities built into candlestick signals creates simple stop loss procedures. Cutting losses is not merely for preserving capital but also for maintaining clear thinking for the next profitable trade.
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