After The Setup: How To Enter, Place Stops, Trail Stops and Take Profits

Many are obsessed with finding the next setup. However, this is only one part of the trader’s equation. After the setup, you have to enter, set a protective stop, trail your stop and take profits. Below we will discuss these variables and will walk through several examples from a swing trader's perspective.

The entry

In many cases, the setup “triggers” when it trades above the prior day’s high. This means that if the stock made a high of 51 today, then you would go long tomorrow if and only if the stock traded above 51, say at 51 1/16 or higher. Often, a bad trade can be avoided by simply waiting for the setup to trigger. Other possible triggers include a rally above prior resistance or wherever the setup dictates.

The Initial Protective Stop (IPS)

There are various theories about where the IPS should be set. It can be pattern-based, volatility-based or dollar-based.

Pattern-based stops usually go below a significant low. For instance, setting your stop below recent support, the low of a breakout bar or the low of a pullback are several examples of “pattern-based” stops.

Volatility-based stops seek to determine the normal volatility of the market and set your stop outside that level. The theory here is to avoid being stopped out on noise alone.

Dollar-based stops are set at some fixed point away from the entry. Usually they increase with the timeframe of the trader. For instance, daytraders might only risk 1 point per trade whereas swing traders might normally risk several points per trade.

In the markets, there are no “exacts.” Therefore it becomes a matter of personal preference as to where the IPS should be placed. You are less likely to get stopped out when using volatility to set stops, but when you do, your losses will likely be significant when stopped out. A daytrader may be forced into dollar-based stops to keep risk per trade within reason. Pattern-based stops have the advantage of market structure (i.e., support) but like the volatility-based stop, losses can often be quite large.

Taking profits

Once you're in a swing trade, you have to determine where you are going to take profits. Many think they have to be perfectly right by selling all of their position at the exact high. Nothing can be further from the truth. Trying to catch the exact high is psychologically a loser's game. Further, even the best professionals only occasionally catch the exact high. And most will admit that when they do, that it was pure luck. The objective of trading is to consistently make money. The objective is not to be right.

A simple, yet effective, money-management technique for the swing trader is to sell half of your position as soon as your profits exceed your initial risk. Larry Connors has dubbed this 2-for-1 Money Management.*

Let it ride

The old Wall Street adage of letting your profits run is one of the few adages that actually makes sense. The easiest way to do this is to trail a stop. In other words, tighten the stop as the position moves in your favor. This way, when the stock reverses, you’ll hopefully lock in a significant portion of the open profits.

Examples

Let's look at some examples based on the above. For purposes of this article, our entry is above the prior day’s high or where the setup suggests, our initial protective stop (IPS) will be pattern-based and placed below the low of the setup or below a two-bar low in extreme cases, 2-for-1 money management will be used and a two-bar low trailing stop will be used for the remainder of the position.

1. Aviron (AVIR | Quote | Chart | News | PowerRating) sets up up as a mini-pennant--a setup Jeff Cooper has dubbed a Boomer. Go long tomorrow at 43 1/16th, 1/16th above today's high.

2. The stock trades at 43 1/16th and we go long.

3. Place a protective stop below the low of the setup at 41 7/16 for a total risk of 1 5/8 points.

4. The stock hits the 2-for-1 profit target by trading 1 5/8 points (our initial risk) above our entry. Exit half of the position and move the original stop up to breakeven--(2), the same as our entry.

5. The stock implodes and stops us out at 43 1/16 for a scratch on the remaining shares. As you can see, what could have been a losing trade, turned out to be marginally profitable through money management.

1. Tut Systems (TUTS | Quote | Chart | News | PowerRating) sets up as a three-bar pullback from highs. Go long tomorrow at 96 3/8, 1/16th above today's high.

2. The stock trades at 96 3/8 and we go long.

3. Place an initial protective stop (IPS) at 93 13/16, 1/16th below the low of the pattern, for an initial risk of 2 7/16.

4. The stock trades 2 7/16 above our entry so we exit half of the position and move our stop to breakeven (2).

5. The stock sells off and stops us out of our remaining shares for scratch trade. The stock eventually goes higher--but that's life!

1. Cache Flow (CFLO | Quote | Chart | News | PowerRating) set up as a Trend Pivot Pullback. According to the rules of the setup, go long 1/16th above the pivot high. Therefore, go long at 96 9/16.

2. The stock trades at 96 9/16 and we go long.

3. The low of the setup is over 8 1/2 points away. This is somewhat of an extreme level. Therefore, initial protective stop is placed at 90 11/16, below the two-bar low, for a total risk of 5 7/8. Note: Swing traders willing to re-enter if stopped out may go with a much smaller dollar-based stop, say 2 points.

4. The stock trades 5 7/8 points above our entry and we exit half of our position and move our protective stop to breakeven (2).

5. The stock continues to move in our favor so we trail the stop at two-bar lows.

6. The stock trades below the two-bar low and we are stopped out at 109 3/16 for a profit of 12 5/8 points on the remaining shares.

More information

As you can see, there's a lot more to trading than just finding setups. Above, we have only scratched the surface of what happens after the setup. For more information on money management and managing the position, refer to the following articles:

Money Management (Pt. I): Controlling Risk and Capturing Profits, Dave Landry
Money Management (Pt. II): Rules Of The Road, Dave Landry
Money Management (Pt. III): Insights From The Pros, Dave Landry
Money Management (Pt. IV): Pro Traders Share Their Lessons, Dave Landry with Kevin Haggerty and Jeff Cooper
Position Management (Part I): Initial Stop Placement, Dave Landry
Position Management (Part II): Trailing Stop And Exit Techniques, Dave Landry
Trailing Stop Techniques, Mark Boucher
Ten Tenets Of Swing Trading, Dave Landry

*Connors On Advanced Trading Strategies, Larry Connors