How to Place Stops Using the SafeZone
Where should traders put their stops? This is one of the hardest questions in technical analysis. Stops have to be tight enough to protect capital and also have to be distant enough to keep clear of meaningless swing.
If look at trading in engineering point of view, the concept of signal and noise in engineering can be applied to trading by considering the trend as the signal and the non-trending motion as the noise. To reject noise and allow the signals to come through, filters is designed in engineering. Therefore the stops in trading have to be designed to allow the trend come through and reject the countertrend motion.
The SafeZone Stop was developed by Dr. Alexander Elder and was introduced in his book Come Into My Trading Room. The SafeZone Stop measures market noise and places stop at a multiple of noise level away from the market to protect traders from getting whacked by meaningless intraday swing.
To define the market trend in the SafeZone, the slope of EMA might be used. Traders also need to choose the length of the look-back period for measuring noise level. This length must be long enough to track recent behavior but short enough to be relevant for current trading.
If the trend is up; to measure the average level of noise in the current uptrend, find the average downside penetration for the selected look-back period. The average downside penetration is calculated by mark all downside penetrations during the look-back period and add their depths, then divide the sum by the number of penetrations.
The stops have to be placed farther away from the market than the average level of noise. So the average downside penetration should be multiplied by a coefficient, starting with two, but experiment with higher numbers. Then subtract the result from yesterday’s low, and place the stop there. If today’s low is lower than yesterday’s, do not move the stop lower since lowering stops on long positions is not allowed.
Reverse these rules in downtrends!