A MATHEMATICAL METHOD FOR IDENTIFYING STOPS AND TARGETS USING SUPPORT

AND RESISTANCE AND AVERAGE TRUE RANGE

JEFFREY KAPRELIAN INFINITY FUTURES
j.kaprelian@infinityfutures.com

As a broker, one of the questions Im often asked by clients is how to figure out where to place
stops and targets. There are, of course, many different methods for this ranging from not using
them at all, to volatility based figures. One of the most reliable, in my opinion, is the use of
support and resistance coupled with the Average True Range. Ill demonstrate this principle
using multiple timeframes with two unrelated markets to show how truly universal it can be.

To begin, we must first paint the broad strokes of what defines support or resistance. The most
basic understanding of support is a level where prices fail to make new lows. The opposite
failure to make new highs is true for resistance. They can be thought of as floors and ceilings.

AN EXAMPLE OF SUPPORT AS A STOP LOSS

The following discussion is based on historical charts so keep in mind that past performance is
not indicative of futures results.

The example above is a weekly coffee chart. Once the market makes a double low (#1 and #2)
we can use that as a temporary level of support. Notice how the market retraces at #3, #4, #5
and #6 before it moves away for good. Oftentimes, the exact level (56.234) at which the dotted
line is drawn, is somewhat inconsequential relative to any major price points, 56.000 in this case,
when setting a stop loss.

Note: Stop orders are not guaranteed to be filled at the preferred price the trader states. Once the
stop order has been triggered, it turns into a market order, which is then filled at the best possible
price. The fill price may be higher or lower than the price specified by the stop order.

The reason we move down to the next major number is because of a psychological phenomenon
known as group think. We can assume that most traders think alike and can identify support

and resistance just as easily as the next guy. The difference though is that traders have different
motivations for buying and selling and generally have strong and opposing convictions for the
direction of the market. Therefore, one can assume that trades at or around 56.000 will serve as
entry and exit points in both directions for a great number of traders.

So lets backtrack to point #2. Now that weve established support we still need to figure out what
to do with it. In the context of this article it should act as a stop loss for any long positions. This
does not, however, give free reign for entry prices. It would be impractical to enter a trade at
70.000, for example, and still use 56.000 as a stop loss. A better method is to gauge an
acceptable range of entry based on the Average True Range (ATR).

With the ATR plotted at the bottom it gives us an idea of how far the market has been moving on
average. At the time our support point is identified and we should be thinking about a long
position, the ATR is 4.04.

We use this number to calculate the maximum price wed be willing to pay for a long position.

Highest Entry Price = Support Level + ATR

Similarly, for a short position:
Lowest Entry Price = Resistance Level ATR

For our coffee trade the maximum entry price is 60.274 (56.234 + 4.04).

Similarly, if the goal of this trade is to capture a longer trend we can extend the stop loss with the
same method (56.234 4.04) giving us a maximum stop loss of 52.194.

Stop Loss Range for long positions = Support level ATR

Stop Loss Range for short positions = Resistance level + ATR

Therefore, the rules for this trade would have been:

Entry range: 56.234 to 60.274
Stop loss: 56.234 to 52.194

The same rules hold true for the other retracements to support at levels #3, #4, #5, and #6. While
the ATR is different, the mathematics, and logic, remain the same.

PUTTING IT ALL TOGETHER AND IDENTIFYING TARGETS

Now that weve identified stop loss levels and acceptable entry ranges we can begin to look at
where to exit the trade. Using the same techniques we are able to find an exit zone. The
following example utilizes a 30 minute WTI Crude Oil chart.

First, we identify resistance where the market fails to make substantially higher highs. Once that
is established we can calculate our entry and stop loss zones by adding and subtracting the ATR
from our resistance level (100.75 +/- .31 = 101.06 to 100.44)

We can also identify a swing low on this chart of 98.48. Using the same zone principle we find
the target zone based on that swing low to be 98.90 to 98.06 given the ATR of .42 upon price reentering the entry zone.

From this we can derive our risk/reward ratio for this particular trade using the worst case
scenario. For a short position the worst case loss would be the top of the entry zone (101.06)
minus the lowest point of the entry zone (100.44). The minimum profit target is the top of the
target zone (98.90).

Therefore:
Maximum Loss: 101.06 100.44 = .62 ($620 in Crude)
Minimum Gain: 100.44 98.90 = 1.54 ($1,540)
Profit to Loss Ratio: 2.48:1 (i.e. Minimum gain is 2.48 times greater than the maximum
loss)
(please note: this example does not include slippage or transaction costs)

If you prefer to wait for support to establish itself rather than using a swing low to calculate a
target this particular trade replicated itself in the coming days.

Upon re-entry of the zone we find the ATR at .39. This gives us a new target zone (98.48 +/- .39
= 98.87 to 98.09).

CONCLUSION

Charting is as much of an art as it is a science. The reason support and resistance works so well
for trading is that in the short term, prices are what is known as sticky. Sticky is synonymous
with rigid, and that lets us know that while price may move around to various points, it has a
tendency to return to certain levels.

Trading Futures, Options on Futures, and retail off-exchange foreign currency transactions
involves substantial risk of loss and is not suitable for all investors. Infinity Futures, LLC is a
wholly owned subsidiary of Transact Futures.

About the Author

Mr. Kaprelian is a futures broker with Infinity Futures. He is a member of the National Futures
Association and registered with the Commodity Futures Trading Commission.

2011 Infinity Futures, LLC. All Rights Reserved.