Stop losses are an important part of a trade setup. This tool helps a trader realize when a trade has gone wrong and when it is the right time to exit the trade. Stop loss is powerful when it is placed at objective levels. Pattern stop loss, i.e placing stop loss based on patterns, is one of the most objective ways of placing stop loss. Although this is method is great on Noiseless charts like Renko and Point & Figure charts, this can be a challenge on candlestick charts.

In this newsletter, we will look at a simple stoploss method that can be used to trail the swing trades on candlestick charts. This method will let us trail the stop loss objectively.

The trade setup

The trade setup is a simple swing strategy. We simply want the price to give a breakout from a consolidation of more than a month.

But what qualifies for a consolidation? In terms of classical patterns, these are the rectangle, cup and handle, cup patterns, or head and shoulder patterns. By Swing breakout, we mean that the holding timeframe is for a few weeks (trying to capture a swing). Let’s try to put this strategy in terms of rules:

1. Price above 21 period EMA line

2. The price should be relatively outperforming (30-day EMA above 60-day EMA on Ratio chart)

3. Price is consolidating for more than a month.

4. Entry: Upon breakout of consolidation

5. Initial Stop loss: Low of the breakout candle

The 2 candles stop loss rule

We have now entered a trade. The price is moving in the direction as well. But how do we trail it? When do we know when to exit objectively? We need an objective method for the candlestick charts. For the 2 candles stop loss rule, we use EMA line as a trailing method. But using only the EMA can trigger the trade early on and can lead to fake outs.

The 2 candles stop loss rule solves this issue.

This simple rule is as follows:
The first candle should close below the EMA line. We exit the trade only if the second candle closes below the close of the first candle. 

The EMA line will be 9 EMA. 9 EMA is used to get an early exit. Although, if the trader wants to hold the trade for a longer period, they can use 21 EMA as well. I would recommend the trader to experiment with what works for them. This brings objectivity to using indicator as a trailing method.

To use this method, the trader can simply make a scanner on any of the scanning or screening tools on the Internet. The trader will screen the stocks from their strategy portfolio which would have closed below the EMA line. The next day, the trader can keep an eye on these stock wait till 3:15 or a few minutes after that in order to decide whether to exit the trade or not.

Observe the charts below. The charts of AJANTPHARMA and BLUESTARCO show the price closed below the 9 EMA line but the candle after that didn’t close below the first candle’s close.

The wonderful part of this method is that the entry can be taken on a higher timeframe and the stop loss can be trailed using 9 EMA on that timeframe as well.