Beginning in the middle of December, some indices, equities, and the U.S. dollar broke upward out of a congestion zone.

Let's imagine that a trader wanted to take advantage of the RUT's mid-December breakout with a directional trade with the idea that a Santa Claus rally might carry through to the end of the year. One possible trade might have been a one- to three-week trade with controlled risk, either a call debit spread or a put credit spread. Where would stops go on such a breakout trade? When would the trader know that the premise behind the trade--the upside breakout--had been negated?

RUT Daily Graph after Close, 12/22/14, Graph by Think-or-Swim:

The trendline would cross at about 1193 the next day. Should any stop be set just below 1193? While a trader would understand that the RUT might need to pull back to retest the breakout zone, are we sure that's the right marker for the breakout?

Another Possible Marker for the Breakout:

Some traders could legitimately argue that the RUT actually broke out when it broke above a trendline that could have been drawn (but isn't, on this graph)along the tops of the candles from late November until the gap higher. Those traders might argue that a stop for this hypothetical breakout trade should be placed just below 1174.84, the bottom of that gap, or 1180.61, the top of that gap.

Other traders could argue that, at least initially, the stop should be placed just below a day's standard deviation from the 12/22/14 close, if that close triggered the new trade. Any movement within a single standard deviation over a day's time is just noise, not indicative of a change in direction, those traders might argue. Some would argue that if a trader plans to be in a trade for at least a week, the stop should not be placed any tighter than a week's standard deviation. OptionNET Explorer estimated that a week's standard deviation of prices for the upcoming week would have been from about 1174-1229.

What's it going to be, a stop just below 1193, 1180.61, 1174.84 or 1174? Just pick one, I would advise the trader.

Really, the trader should just pick one depending on that trader's outlook for the trade, the proportion of trading funds devoted to the trade, the trader's comfort level with risk and the decision about what marked the breakout. I would not suggest making the stop any tighter than a single day's standard deviation, at least. Nor would I suggest putting a stop exactly on a round-number level such as 1180. That trader and umpteen dozen others would just be asking to be stopped out on a retest of 1180, whether the RUT was eventually able to maintain support there or not.

Why am I being so cavalier? I'm not really cavalier. I'm realistic. This is a directional trade that's being considered, and directional trades require traders to make some decisions about what constitutes a change in direction. The trader should build a scenario around the level that marked the breakout in calm times, before the trade is entered and while rational decisions prove easier. Once the trader decides on the level that marked the breakout, decisions aren't done for that hypothetical trader.

If the trader decided that a drop below 1180 constitutes a change in direction, the trader has to decide whether that means a daily close below 1180 or an intraday close below 1180, such as a 30-minute or 15-minute close below it? Since we're talking about an intended one- to three-week trade, our hypothetical trader probably doesn't want to exit based on a one-minute or five-minute chart but certainly might want to do so if the trade had been intended as an intraday trade.

If a thirty-minute close beneath 1180 is going to signal that there's a change in trend in our hypothetical trader's scenario, is the trader really going to put the stop at such an obvious round-number, support/resistance level or somewhat below it, say at 1178.50-1179? The trader should pick a number that's not a round-number that everyone is watching, perhaps 1179 in this case. See how easy that is when you're making the decision in calm times when you're not in a trade? I'm joking, but it's really not a joke that these choices are easier when your emotions are not yet tied up in a trade.

Going a little wider with the stop is going to benefit traders those times when the RUT pulls back a little and then takes off again, and keeping it as tight as possible is going to benefit traders when the RUT pulls back, hesitates and then plunges lower. Traders don't know ahead of time which is which. As traders gain more experience with trading and with the behavior of the preferred underlying, traders might make decisions based on perceptions of current market conditions, but until then it just makes better sense for our hypothetical trader to determine the best stop, in the trader's judgment, and stick to it. Let's say our hypothetical trader decides that a 30-minute close beneath 1179 will trigger the exit, at least over the next day or so.

Now it's time for the trader to set up a hypothetical trade and determine how much would be lost if the RUT retraced to 1179 before there's even a change in trend in the trader's eyes. This is necessary before the trader knows if the trade entry makes sense. This is part of the testing each trader should do before ever entering a trade. It gets faster, the more traders go through these exercises.

Example RUT Call Debit Spread, OptionNET Explorer Graph:

The maximum loss on this trade would have been its cost, theoretically about $3,960, including two-way commissions. Of course, prices at the open the next day are unlikely to be exactly the same. However, this exercise is meant to provide enough information to decide whether the trade setup, with the settled-upon stop at 1179, makes sense. I've rolled the time forward a day, shown in the "T+1" designation. From our vantage point now, we know what happened, but the trader considering a trade that day didn't, and neither did I when I was roughing out this article on the day pictured. I was using the same tools I would have been using if this had been my trade I was considering.

We see from the colored vertical bands that that arrow marking 1179 coincides roughly with a one-day 1.5 standard deviation move from the 11/22 close. It meets the parameter of being at least a single day's standard deviation away.

I can't snap the second pull-down menu that shows the exact theoretical loss at 1179, but I can read it on my ONE, and it's about $1,046 or 26 percent of the investment in the trade. The potential profit for the trade is a little over $2,040, although the trade would probably have to held until very close to expiration to collect all that profit. Still, there's a potential to profit almost double what you would lose if the RUT did reverse and hit the level you've identified for your stop. I have to pause here to note that of course you don't always have the luxury of closing the trade at your stop. In rare occasions, the underlying might gap below your stop one fine morning. That risk must be acknowledged, but this trade also has a defined maximum risk, the amount invested plus commissions.

Back to our consideration of the amount that would be lost if the stop were hit, we see that the loss would sting. However, if a trader felt strongly about the breakout's sustainability and wanted to participate in a breakout, that trade might have been worth the risk for that trader, with a potential profit that's double the intended risk at the stop. I wouldn't have been participating in the trade because I would have been paying too much attention to nearby resistance and I trade directional trades only a few times a year. However, we know now, with hindsight, that the RUT traveled much higher, up to 1221.44, before it started pulling back sharply. Readers eyeballing that expiration chart could guess that our hypothetical trader could have profited handily by the time the RUT hit that level. Theoretical profits early on the morning of December 31, before the RUT started down, were about $760. If the hypothetical trader had not raised the stop as the RUT traveled higher, that theoretical $760 profit from December 31 would have been transformed into a theoretical $135 loss at the close on Friday, January 2.

That brings up another consideration for the hypothetical trader. Is the original stop the stop throughout the trade? Many traders keep moving stops up (or down) as the price moves so that they don't let a profitable trade turn into a losing one. It would have been a good idea to set a profit target before entering the trade and also to decide how stops would have been handled as the RUT took off higher.

Sometimes, the logical placement of the initial stop renders the trade unworkable from the beginning, no matter how certain a trader might be of the next direction. That's because the most logical stop is either too tight--within the normal noise level for the time period in which the trader would be in the trade--or too far away--so far that the trader would have lost all or almost all that was invested in the trade before the stop would be hit.

Think about your stops before you enter a trade, no matter how certain you are of direction and how tempting the development you see right in front of you. You have to know how you'll tell you're wrong and whether finding out you're wrong by being stopped out will cost too much.

Linda Piazza