A more sensible way to determine stops would be to base it on what the charts are saying.
Since we’re trading the markets, we might as well base our stops on what the markets are showing us… Makes sense, right?
One of the things that we can observe in price action is that there are times when prices can’t seem to push or break beyond certain levels.
Often times, when these areas of support or resistance are retested, they could potentially hold the market from pushing through once again.
Setting stops beyond these levels of support and resistance makes sense, because if the market does trade beyond these areas, then it is reasonable to think that a break of that area will bring in more traders to play the break and further push your position against you.
Or, if these levels DO break, then there may be forces that you are unaware of suddenly pushing the market one way or another.
Let’s take a quick look at a way to set your stops based on support and resistance:
On the chart above, we can see that the pair is now trading above the falling trend line.
You decide that this is a great breakout trade setup and you decide to go long.
But before you enter you trade, ask yourself the following questions:
Where could you possibly set your stop?
What conditions would tell you when your original trade idea is invalidated?
In this case, it makes the most sense to set your stops below the trend lines and support areas.
If the market moves into these areas, that means the trend lines drew no support from buyers and now sellers are in control.
Your trade idea was invalidated and it’s time you to suck it up, exit the trade, and accept the loss.
If you want a real life example, take a look at Huck’s trend line play on EUR/USD!