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Stop Losses and Follow-Up Stop Losses on Gap Trades.

Frequently, gap lower or higher openings will produce fairly large moves within the day time frame. The professional day trader will want to maximize on these signals not only by having a specific stop loss but also by attempting to lock in as much profit as possible so that in the long run overall risk exposure may be minimized. I cannot overemphasize this last point. In order to do this I offer the following suggestions regarding stop losses and trailing stop losses:

Вц When a gap signal trade has occurred, make certain that once you are in a reasonably profitable position, you place a stop loss to exit that position at your commission cost plus a small amount of profit so that if the market reverses course, you will have been stopped out without losing any money in most cases. As far as follow-up stop losses are concerned I suggest that you develop your own procedure. In terms of dollar stop loss, a deciВэsion should be made on a per-market basis. In S&P futures for examВэple, a 150 point or $750 lead on the market is a reasonable point at which to consider placing a stop loss at break-even plus commission or slightly higher. Remember that if you are "scalping" the market you will want to use an even closer follow-up stop loss.

Вц Multiple units or contracts may be considered as one way of maximizВэing your potential profit without significantly increasing your overall risk. Consider the following procedure: Rather than establish your iniВэtial position with one contract, you establish your initial position with two contracts. Assuming the market moves in your favor, you exit one contract at a predetermined target either determined technically or on a dollar basis while you retain the remaining position with a specific breakВэeven plus commission and small profit stop loss to protect you during the day and exit the position on the close or shortly before the close. The multiple contract procedure combines, what I feel is the best of both situations, allowing you to have your profit and keep your trade as well.

Вц A trailing stop loss may also be used. Although there is evidence to sugВэgest that trailing stop losses for position trades do not work well, this is not necessarily true for day trades where the time length of a posiВэtion is clearly finite. In the case of a runaway move in your favor, I suggest you follow up with either an hourly or a half-hourly stop using the last half hour low or high as your stop loss point. So, for example, if you have entered an S&P gap trade on the long side which then moves sharply in your favor and continues to move in your favor for a fairly extended period during the day, follow up that position by placing a stop loss below the low of the previous half hour or the preВэvious hour if you prefer. In the case of a short position which has moved strongly in your favor, follow up by placing a stop loss above the high of the previous half hour or hour if you prefer and change your stop loss every hour. By doing this, you will be taken out of your position fairly quickly once the intraday trend has reversed itself.

Вц Three-bar stop loss procedure. In addition to the hourly or half hourly follow-up stop loss procedure recommended above, consider using a trailing stop loss below the lowest low of the last three price bars for long positions and above the highest high of the last three price bars for short positions. In other words, if the last three 5-minute price bars show lows of 34.50, 34.20, and 33.97, then your trailing stop loss for a long position would be below 33.97, since this is the lowest of the three lows. When the next bar posts you can change your stop loss if necessary. In the case of a short position, your trailing stop loss will be above the highest of high the last three price bars.

Remember that these stop losses must be mental stop losses. Don't keep changing your stop loss every 5 minutes, or both you and your broker will go crazy, and you will be reprimanded.