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Breakout Trading Strategy: How to set stop loss

Updated: Dec 28, 2021

Last week, we had entered SGMS options with 5 weeks time frame. SGMS stock had gone to 76 from a breakout area of 71 and retraced back. In the process, options had a profit of more than 50%. Usually, we recommend trimming the position at 50% and above . When the stock retraced back , one of the subscribers had asked if we need to exit the position. I looked at the charts to see if the condition on which we had entered is not broken yet and if the stock has reached any resistance yet. It had not. So, I would be patient and manage my position based on the stock price action.

There are two kinds of stop losses - money (hard) stop loss and technical stop loss. Money stop loss is set in such a way that you exit the trade when the stock goes below your buy price either by a certain amount of dollars ( could be cents too) or by a percentage. There are variants of the hard stop loss such as trailing stop loss which is more effective in controlling the losses . This stop loss is used to ensure we do not lose more than predetermined amount in any trade. Technical stop loss, on the other hand, is set in such a way that you exit the trade when a particular support or resistance identified is breached or broken.

Breakout trading strategy enables you to enter a trade when a particular support or resistance is broken and is heading further in the same direction. This strategy lets you stay in the trade until the next support or resistance is reached. Some of the ways we can identify support or resistances for this strategy is by using flat lines, trend lines, fib retracements and projections, Gann etc.

I love this strategy because it minimizes risk when we enter the trade. I love to enter a trade very close to breakout area with my stop loss ( this is technical stop loss) right below the breakout. Let us look at an example to understand how position sizing and risk reward ratio works in this strategy.

for simplicity, assume a portfolio of 500k with a position sizing of 2%($10000). for each trade.

Also assume there is a stock ABC right now at 10 and has a support at 9. as per CPR ( cost purchase risk) model, P ( Number of shares ) = C/R= 10000/(10*(10-9)) = 1000 shares. If the support is at 8, P - 10000/(10*(10-8)) = 500 shares. If the support is at 9.50, P would be 2000 shares. Here, P is the number of shares purchased with the intent of selling them if the support considered is breached.

Breakout trading strategy can be rewarding but may require patience sometimes as there might be accumulation happening for days around the breakout area before advancing further. I would prefer to use a technical stop loss when I enter a trade based on breakouts. Also, I would try to enter the trade as close as to breakout to minimize my risk.

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