Stop Losses Using a Moving Average Channel
Here are some notes I took from a video by Pete Birchler of Stock Market Alchemy in which he discusses the Moving Average Channel trading method outlined by futures analyst and trader, Jake Bernstein in his book, The Compleat Day Trader .
Pete talks about creating a chart study using two moving averages to provide a systematic way to find the best places to place trade stops.
To create the lower part of the channel, he sets a Simple Moving Average (SMA) of 8-periods, but he instead of using the standard Close value, he chooses the Low.
For the upper part of the channel, he sets a second SMA (and changing to a new colour), but this one is set to 10-periods and, this time, he chooses the High.
These channels can be used to take a trade when a buy signal is triggered when two consecutive bars trade completely above the channel. IN this case, a position would be taken on the next trading day.
Conversely, a sell signal is triggered when two consecutive bars trade completely below the channel.
However, if you are using another trading methodology to get into the trade, you can use the Moving Average Channel to place stop positions and stay with profitable trends.
Once you have an entry signal for your trade, you will place your initial stop (as determined by your trading methodology, e.g. below a prior level of support).
Once in the trade, we will look for times when the price moves to touch the lower line of the Moving Average Channel and then moves to a new high for the trend (i.e. as soon as it breaks the price high), we will move our stop upwards to one penny below the low of the bar that touched the lower channel line.
You would move the stop up again with the next touch of the lower channel line. You can do move the stops indefinitely.
You can also vary the time frames to find exit points that will allow you to exit a portion of your trade if the stock is volatile. Changing the time periods, for example from a daily to a weekly chart, the price will touch the lower channel at a different price level and so offer a different stop price.