The danger of setting your stops too close

Last week, I wrote about some gold trades: Four key traders lessons that will keep you in the game. I left it with the market trading above my central tramline T1:

Gold spread betting chart

(Click on the chart for a larger version)

I then stated that I would be setting a sell-stop to enter a short trade just below T1. I also said that I would be setting a protective buy-stop of around $5 on this trade. 

I suggested that if T1 were to give way, my first target would be the lowest tramline, T3.

So let’s see how this action developed.

What happened next?

Right after this, gold did indeed drop down and broke beneath T1 – and I was stopped in at the $1,542 level. I then placed my stop at $1,547. The $5 risk was well within my 3% Rule.

Gold spread betting chart

(Click on the chart for a larger version)

As you can see, the market did fall to T3 at the $1,534 area on June 9.  

Very short-term traders would be offered the chance to take profits there of around £80 per £1 spread bet.

But I decided to move my stop down to break-even following my Break-Even Rule. There was a paper gain of $8 and I wanted to give this trade room to work lower, if the market wished to cooperate.

Stopped out on a vicious spike

But as you can see, in the afternoon of Thursday June 9, the market rallied through my stop, taking me out for a break-even trade (a “wash”). And it carried right on to spike above T1.

These spiky overshoots are common in gold, which makes gold trading very tricky in the short-term.

The market then reversed course and is currently heading lower – as I originally forecast! 

In fact, the market has fallen to my even lower Tramline at the $1,526 level.  This is annoying, as I believe gold has the potential to move very much lower – and I don’t want to miss this trade.

So, how should I approach this market? 

It is clear that setting very close stops is generally a poor idea – unless you get lucky.

For me, it is far better to first focus on the larger trends (if any) on the daily chart, and then go to the hourly chart. 

Here is the current situation:

Gold spread betting chart

(Click on the chart for a larger version)

If I believe the May 1 high at $1,577 will stand for some time – and I have good reasons for this view – then the current rally is a retracement of the sharp May fall. 

That means the rally will likely stop at a Fibonacci retracement. And so it has (so far!). 

Note the weakening momentum (marked by green arrows) as the $1,550 level was approached – a bearish sign.

Getting back to the question of how to trade gold here, the current market is only about $20 off the retracement rally high.

So a trader who is able to set a wider protective stop could short anywhere here and set the stop just above the $1,550 level.

If the market rallied back to this area, it would likely negate my retracement idea.

And this style of trading would get around the annoying habit of gold to make spiky moves which stop us out prematurely.

As ever, it is very much a personal decision which trading style to adopt. There is no “best” way to trade for everyone. As a trader, you must work on your own style and develop it. 

The good news is that, as with most things, the more trades you do, the more efficient you become. And having some background knowledge such as this can help you make an informed decision.

Also, the more you study the charts and observe the action around Fibonacci retracements and the tramlines, the more ‘in tune’ with the markets you become – making you a better trader.

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