Setting Stops Using Support & Resistance Levels

Setting Stops Using Support & Resistance Levels

If you've ever executed a trade and saw the market hit your stop loss before it immediately reversed back into your favor, then I am sure you know the frustration.

One of the key factors at play here is often that you are placing stops without regard for the presence of a support or resistance area. These areas act like invisible walls on your price chart, and learning how to use them effectively can greatly assist you in your stop placement.

Why Support and Resistance Matters

Support is simply an area on your chart where buyers are stepping in to buy and prevent price from falling any further. Resistance is an area on your chart where you have sellers stepping in to stop price from climbing any higher.

It is not random, these levels exist largely because of psychological patterns exhibited by groups of traders. Market participants recall important zones of price, and when the market returns to those zones, the market will tend to repeat the same behavior.

Placing stops without regard to these zones presents unnecessary risk. If, for example, you placed your stop loss only a few pips below a zone of support, you are essentially giving the noise of the market and its natural movement an invitation to knock you out.

However, allowing the trade a buffer below a support area (for a buy) or below a resistance area (for a sell), you are more likely to stay in the trade when the level holds.

How To Identify Support And Resistance

You don't need fancy tools or setups to be able to locate these areas. Usually, a good look at a price chart will provide you with the necessary information.Find areas that price has been rejected from or has had quick reversals from multiple times in the past. Round numbers (1.2000 in forex, and $100 in stocks) also tend to act as good psychological levels as well.

For example, say EURUSD has bounced off 1.0850 which has been an area of 3 rejections over the past month. This is your area of support. If you're going long, it makes sense to put your stop-loss just below that area, and not right on it. 

Think of the stops in relation to support and resistance as follows in this quick table:

Don't make "Too Tight" of mistake

One mistake new traders make is putting their stops to close to their entry. While it might feel safe to lose less, stops that are set too tightly get triggered by normal market movement. You should think of it this way. If you stop your car on a busy street, you're going to want to leave some space between the line of cars passing you.

Instead of only thinking about losing as little as possible, consider finding balances of risk and phrasing point of market structure.

For example, if you have your support 30 pips away, then why put a stop-loss 5 pips below your entry? It is always better to calculate position sizes before hand so you can leave the stop-loss in a safer area of your risk but also be able to manage risk. 

Using Along With Other Tools 

Support and resistance become even more important when confluence with other forms of confirmation is being used.For example, if a moving average or trendline coincides with a support area, that area becomes significantly stronger.

Also, some traders will use candlestick patterns (the presence of bullish engulfing candle at support) to add some confidence before staking their stops.

The point isn't to complicate everything but to stack probabilities in your favor. The more evidence you have that a level is important the more reasoning to set your stop just beyond it.

A Simple Example

Let’s say, you are trading GBP/USD. The pair has bounced from 1.2600 three times in the last week. You've decided to go long at 1.2620, expecting the level to hold once again. Instead of setting your stop at 1.2599 (just underneath support) you would place it at 1.2575, a comfortable distance that allows for if there are any “stop hunts,” or market noise.

You have now lowered your risk of being shaken out prematurely but you still protect yourself when the level is truly broken.

The Bigger Picture

Of course, there is no perfect methodology. Support can fail, resistance can break, and almost always stops will get hit no matter where they are placed. That’s part of the deal.

However, rewarding your stops in relation to supporting and resistance levels helps you to rationally place your stops as opposed to guessing. It changes the nature of your decision making from “random numbers,” to decisions based on how the market has acted previously.

Final Thoughts

Stop losses are there to protect you. However, how you place them can considerably impact your decision whether you will get shaken out early and miss a profitable trade.

When you utilize your stop in conjunction with support and resistance levels you create a rational basis of your trades and in doing so eliminate some of the randomness of your losses thereby increasing your overall consistency.

If you want to go deeper into practical step by step trading strategies and risk management techniques don't hesitate to explore more in the Learn section of Wikilix, and keep on building your trading knowledge step by step!