There should always be a price at which you say your outlook is wrong. The protective stop out level is that price. No matter how reliable the technical tool, there will be times when the signal obtained from that tool is wrong. By using stops, you are defining the risk of a trade. ln effect, the use of stops provides one of the most powerful aspects of technical analysis; it offers a risk management approach to the market.

Many of the candlestick patterns can become a support or resistance area. For example, a dark cloud cover often acts as resistance. As such, for those who are short, a protective buy stop can be placed on a close above the high of the dark cloud cover. In Exhibit 4.1., we see that an uptrend that started in early January stopped via a dark cloud cover as
the market went from an uptrend preceding this pattern into a lateral band after the dark cloud. The dark cloud cover acted as resistance for the next 7 sessions. But the rising window and then the close above the high of the dark cloud cover were signs that the market was ready to once again advance.

It is human nature that when price action turns against you, wishful thinking enters the picture. For instance, after the market pushed above the stop out level in Exhibit 4.1 (the high of the dark cloud cover), some traders who were short may have hoped that the market would then turn around and decline. But in the market, there is no room for hope. Staying in a market that moves through a stop out level in the hope that prices will then turn is, as a picturesque Japanese proverb states: “To lean a ladder against the clouds.

In Exhibit 4.2, we see that a rising window emerged in April 1993. Based on candle theory, this window should be support, as it was during the September 1993 pullback. Whether a trader bought on a pullback into the window, or whether he or she was previously long, a protective sell stop should be on a weekly close (i.e., a Friday close) under the bottom of the rising window. Note how, in this market, the window was pierced on an intra-weekly basis, but the bears did not have enough staying power to maintain prices under the bottom of the window by the close of the week. In this case, the window held as support, but not all traders would have been able to stand the emotional ride in this market as prices pulled under the window and then sprang back above the bottom of the window before the Friday close. This example illustrates how trading depends to a large extent on a trader’s temperament.

As shown in Exhibit 4.3, Amgen held the rising window as support when it pulled back to there in November. The successful test of the rising window confirmed the health of the market. The rebound from the successful test of the window pushed prices above $75. At that point, the market gave some clues of trouble based on a harami pattern. over the next few weeks, the market started to top out via a classic head and shoulders pattern denoted by S-H-S (the Japanese call the head and shoulders a Three-Buddha Pattern). When prices penetrated the neckline of this head and shoulders top, it should have been a sign for longs to exit. A final warning about the weak state of the market was given when, in early 1993, the bears finally managed to drag prices under the rising window, which heretofore had been support. This break of the window could have been another protective sell stop signal for existing longs.

Source/Credit : Steve Nison