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Volatility Adjusted or Volatility Based Stop Loss & No Math
. The Trailing Stop Loss Can Lock in Profits on a Rising Stock. As a stock rises, the price of the stop loss is raised. When the stock begins to fall, the order is triggered and a big part of the gain is "taken off the table." When the pattern of a rising stock does not manifest any clearly defined levels of support that can be used to formulate a stop loss strategy, an alternate approach must be used. Probably the most effective of these is to measure the volatility of the stock and from that measurement determine the maximum range of excursion likely for the stock over a given time. A common practice of traders is to set their order just beyond the limits of the stock’s probable excursion range. This approach makes use of the laws of probability. That is, a sample of the stocks behavior pattern is taken and a statistical analysis is performed to see how much fluctuation is "normal" for the stock (this can be achieved without mathematical expertise or procedure on your part, so don't get discouraged). The stop loss is set outside the normal "lurch & jerk" range of the stock. Hence, the normal "noise" (random fluctuation) in the stock’s behavior is not likely to trigger the stop loss. Such an event is, by definition, improbable. Only an event that causes the stock to fall an unusual amount relatively quickly would do that. Use common sense when you purchase. It is not wise to place a stop loss 10% below your purchase price if you purchase the stock when it is 12% above its support. Trending stocks tend to revisit the rising support levels represented by the trendline. That means your 10% stop loss is likely to be triggered even if nothing of significance has happened. If a stock returns to its trendline, that does not mean it has made a significant change in direction. It is normal for stocks to do so. If, on the other hand, you buy when the stock is only 1% to 2% above support, your 10% stop loss will not be triggered unless the stock falls enough to penetrate all the support that exists just above your stop loss order (in this case that's a penetration of 8% or more, and it is not easy to punch through that much resistance). That support represents buyers. If the sellers can overwhelm all the buyers waiting to buy just above your stop loss (and they will have done so if your stop loss is triggered), then something very significant and very negative has happened. Under those conditions, you want your stop loss to be executed. Swing traders usually adjust their stop loss every day. They may even adjust the stop loss one or more times during the day if the price changes significantly. Intermediate-term and long-term investors might get by with weekly adjustments. Most swing traders have a targeted holding period of a few days to a month. Such a trader might prefer to use a stop loss of about 3%. Though most experienced traders base their stop losses on the action and volatility of the stock rather than on a straight percentage, many traders/investors do use a percentage-based stop loss successfully so we’ll use that approach here (check our Tutorial #24 for more on the volatility-adjusted stop loss). Thus our hypothetical trader might place his stop loss 3% below the highest low, close, or high reached by the stock since its purchase (he might place it 3% below the highest high to lock in most of any upward surge). One strategy he could use is to keep the stop loss 3% below the highest low until the stock accelerates or surges. If the stock suddenly surges, he could then follow the stock up with the stop loss placed 3% below the highest high. That way, when the stock collapses, he will lock in a greater percentage of the gain achieved by the stock before its meltdown. More aggressive traders will use even tighter stop losses than 3%. Some will use 3% below the highest close or 2% below the highest low, and so on. These have a shorter time horizon and are attempting to capture the gains from short-term surges in price (where the percentage gain is greater for the amount of time invested). Shorter-term traders might place their stop loss ten cents below yesterday's low. The specifics of stop loss placement are tied to investment time horizon. The trader must determine what kinds of stock moves he wants to capture. Stop losses based on volatility or definable support are much less likely to be triggered by a random fluctuation in price. Some will use the ATR (average true range) in calculating the stop-loss, but we will not go into that right now (our Stops tool has that computation already built-in). Others will base their stop-loss on the 20-day (or 4-week) low. The thinking behind this approach is that if the stock falls below the lowest price it has seen in the last 4 weeks, then it is no longer trending upwards. Therefore they place their order just below that low (this price is provided for each stock in The Valuator). More aggressive traders base their stop-loss on a 10-day low or some shorter period. If there is a definable trendline, traders will often set their sell price 3% below the current value of the trendline if closing prices are used and an order is not actually placed with a broker (this is called a "mental" stop loss). However if the stop loss is to be exercised in real time while the market is open, many traders will place the sell order a little more than 6% below the current value of the trendline. The greater distance is to compensate for the fact that there are often intra-day spikes that could unnecessarily trigger a sale. The closing price is the final valuation given to the stock and it is the price at which traders are most comfortable leaving their money committed overnight. This figure has less volatility than the low or high. Therefore stop losses that are based on the close (and therefore are not triggered by intra-day spikes) can be closer. Think about it. Stop-loss orders are for the investor similar in function to the safety lines used by mountain climbers. Of course you are confident that the stock is going to rise when you make your purchase. That's why you bought the stock. Everyone makes mistakes! A stop-loss is simply your safety line if you are wrong. If you do not believe you can be wrong, do yourself a favor and stay away from the stock market. Nearly all of the top traders and investors incorporate the stop-loss as an integral part of their discipline. A trader who does not use a stop-loss is, like a circus high-wire performer who abandons the use of a safety net, asking for trouble. If you do not use a stop loss, and if your stock plunges while you are away from your monitor, or if you are too slow to act because of confusion or indecision for some reason (perhaps your indicators are unusually ambiguous), you could lose nearly all of the value of a position (margin traders could even lose more than what they invested). As we said before, top traders use stops that rise along with the stock. In doing so, they usually employ volatility-adjusted stop-losses because this approach is far more nimble as it automatically adapts to the statistical variance in the behavior of the stock. The Stops tool makes it easy to know where to place each higher stop loss as the stock rises, while simultaneously factoring in the volatility of the stock. No math is needed. The tool automatically computes a stock’s volatility and provides each new setting as determined by the stock’s own behavior. There is a "lab" in the Stops tool where you can experiment with different tool settings. The "lab" has a 5-year stock chart with a red line that traces the placement of the stop loss. In the "lab," you can observe the effect of your different tool settings on the stop loss line and discover which settings work best for you. Then you simply enter the settings you prefer and Stops will make the math computations for you. The Stops tool facilitates a disciplined approach to trading and investing. It helps eliminate emotion from the sell-decision. Our Stops video should be interesting and informative regarding volatility-adjusted stops, even for those who have no interest in the Stops tool (use the blue link below to see it). Below the blue link is a description of the tool.
A Brief Description The following image is a sample of a Stops page layout. Click on the illustration below to enlarge it.
Sample of a Stops Page Stops is our software tool for calculating the changing stop-loss settings of a rising stock. One problem traders and investors face is how much to let a stock decline before selling. Our tool addresses this issue. The ideal stop-loss strategy will minimize the loss if the stock plummets but still give the stock room for normal fluctuations while it continues to climb. Correct stop placement is one of the most important disciplines a trader can learn. The problen is that in order to determine the correct placement of a volatility-adjusted stop-loss, it is necessary to use some math. The Stops tool makes the calculations automatic. The only thing left is to implement the tool's readout in accord with your trading or investing disciplines.The tool includes a "Stop-Lab" where you can experiment with different settings and strategies and see the effect on the stop loss of variations in your settings on a stock-chart covering over 5½ years of price activity. Stop-loss placement is indicated by a red line that changes as settings are changed. When you find the settings that work the best for you, those settings can be entered for each of 10 different stocks. Or, you can enter a different setting for each stock. The tool will then automatically compute stop-loss settings for you as you enter price data. Stop-losses can be based on a fixed-percentage decline or on the volatility of the stock. You can also generate stop losses that combine fixed-percentage and volatility-adjusted disciplines. The tool can calculate and use volatility measurements to compute stop losses that have a low probability of causing an unnecessary sale because of random lurches of the stock. It includes a variety of strategies (19 different ways) to calculate a stop loss, each of which has an infinite range of adjustment possibilities (so you can adjust them to reflect your own tolerance for risk). It will use average deviations, standard deviations, and "true range" equations derived from the work and thinking of Kase, and others. Stops does all the math for you. All you have to do is enter date and price information, and the calculations are done automatically. The tool gives the changing stop loss price as new date and price information is entered.
General description The Stop-Loss Whether a person holds stocks for a few days or for many months, he must make trades. One of the rules of good trading, and of good investing in general, is to "limit your losses and let your profits run." This phrase is often heard in investment circles, but it is not often implemented with discipline. It’s another way of saying that for the best returns a person should hold onto a stock only as long as it is climbing and sell quickly when it starts to decline. The use of a stop loss order that follows a stock up as it climbs higher and automatically sells when the stock falls is one of the best strategies known for doing precisely that. It is also the easiest to implement. Calculating the stop loss helps a person define when a stock has started to decline. Because the tool makes the computations automatic, you can spend your time on other parts of your strategy or on refining your discipline. The tool relieves you from the stress of determining where to place your stop loss order each time the stock ratchets up to a higher level.
Ideal stop loss disciplines will minimize the loss if the stock plummets. On the other hand, they will also give the stock room for normal fluctuations while it continues to climb. Placing the stop loss too close to the stock will cause an unnecessary sale. Placing it too far away will result in too much loss if it is triggered. That’s why the volatility of the stock should be calculated and factored into the determination of the stop loss. The measurement of volatility, tells you what "normal" fluctuation is for a particular stock. Conversely, it also tells you what is not normal for the stock.
While teaching others about trading and longer-term investing, I learned that most people do not know how to compute that kind of stop loss. If they use stop losses at all, they tend to use a rather simplistic one that does not factor in the volatility of the stock. Therefore, their stops tend to be triggered too quickly because they are too close to the stock or too late because they are too far from it. I give subscribers to my training programs and investment models the stop loss placements computed by those models. Most would not be able to make the necessary volatility-adjusted computations on their own. Even those who have the mathematical know-how to make the necessary computations would find it too tedious and time-consuming to repeatedly compute revised volatility-adjusted stop losses for each position as it works its way up to higher levels.
Understandably, traders and investors would much rather spend the time searching for attractive "setups" or planning their next move. Unfortunately, the use of "sloppy stop losses" explains why so many people get much lower performance from their portfolio than they should, and the fact that so many use no stop loss at all explains why so many get "killed" in the market. Adopting a habit of always using correctly placed volatility-adjusted stop losses could add an extra 10% or more to the return of a portfolio. Traders need to be able to find the optimum place to put a stop loss without having to make time-consuming statistical calculations.
There are stock-charting programs available that will automatically do the computing, but those programs tend to be very expensive and users must still write the equations. Another problem is that some very expensive programs (including one that almost every trader has heard of or used) default to an incorrect statistical procedure when generating a volatility-adjusted stop loss. Also, most of those programs require that a special syntax unique to the program be used in constructing formulas. One person I know has done graduate-level work in applied mathematics. He has used one of these programs for four years and still has not figured out how to write the simplest stop loss formula so that the program will use it correctly. The math is easy for him. He just hasn’t been able to spend the time it would take to learn how to express his equations in the peculiar syntax necessary for the program to behave correctly. The producers of the program expect their customers to help each other figure out the syntax by using a Web-based forum to share what they’ve learned through trial and error. These users have learned not to expect much help from the software company. The Stops Solution Traders do not want to spend their time studying program syntax and non-intuitive procedures, and I have found no inexpensive easy-to-use tool I could recommend that will automatically do the math required to compute a sophisticated stop loss. So I developed one myself. I call it Stops. Stops is based on and makes use of an Excel spreadsheet. It provides 19 different ways to compute a stop loss and each of these can be infinitely adjusted by the user. All you have to do is enter a few numbers ("1," "2," or "3") to control the way stop losses are computed. For example, entering "1" in one box might tell Stops to use a particular procedure to measure volatility, entering "3" in another box will tell it to subtract whatever percentage you choose from the highest high, low, or close (according to your selection), and so on. Stops includes a Stop-Lab where you can experiment with different settings and see the effect of those settings on a stock-chart covering over 5½ years of price activity. Stop loss placement is indicated by a red line that changes as settings are changed. Stop losses can be based on a fixed-percentage decline or on the recent price action and volatility of the stock. Volatility-adjusted stop losses use volatility measurements in an effort to avoid unnecessary selling because of random lurches of the stock.
You can also generate stop losses that combine the fixed-percentage and volatility-adjusted approaches. You can even select the relative weighting that each approach will have. Furthermore, you can control the amount of influence the volatility measurement (such as the standard deviation, average deviation, etc.) will have on the stop loss. Stop losses can be computed relative to the high, low, or close. Rising stop loss points are automatically computed for you as stocks rise (for up to 10 positions). Once a few simple settings are made, all you have to do is enter data for each day. This data consists of the date, open, high, low, and close. That’s all there is to it. The stop losses are automatically computed and displayed as data is entered. You can even enter the high and low prices of a move to have Stops calculate Fibonacci retracement levels for you (traders often make use of them in placing their stops). Fibonacci ratios appear throughout nature. They appear in branching plants as they grow, in the number of petals on flowers (lilies, irises, buttercups, etc.), starfish, sand dollars, the shell of a chambered nautilus, snail shells, sea horses, the horns of some animals, and in the proportions of the human body. Elliot Wave Theory makes use of them in stock market trend analysis in which five upward waves and three downward waves form a complete cycle of eight waves. All of these numbers are Fibonacci numbers, and these relationships can be applied to both short-term and long-term trends. Many traders use the Fibonacci relationships in stock behavior patterns to find areas of support and resistance and to help in stop loss placement. They will often wait until a stock reaches its Fibonacci support level, buy as soon as the stock responds to that support, and then place their stop loss immediately below the support. This is a low-risk purchase because the stock is bought just above the stop-loss. Stops will calculate mathematically and strategically sophisticated stop-loss settings on the basis of simple date and price information supplied by the user. It is intended for people who do not want to spend a lot of time making mathematical calculations or who do not want to pay a large fee to use a program that probably will not make it any easier to compute a good stop loss.
Even with very expensive software, either because of the strange non-intuitive syntax required by the program or because of the lack of sufficient mathematical expertise on the user’s part, it is often very difficult for most users to write a volatility-adjusted stop-loss formula that the program will use correctly. Without such software, and the mathematical expertise often needed to use it, traders have to rely on "eyeballing" charts (this can be quite sloppy and result in more than necessary loss) or on making their computations manually. Any manual calculations have to be very rudimentary because the more sophisticated computations are too time-consuming. Rudimentary stop losses are usually the first to get triggered unnecessarily because of market "noise." These stop losses may also give up far too much money when they are triggered. Even one excessive loss of .50 on a 500 share trade would cost far more than the price of using the tool for a full year. On the other hand, how many people want to take the time to compute a stop loss based on standard deviation? How many know how to compute a standard deviation? Those who know how do not want to spend all the time it would take to make the more sophisticated computations for all their positions, let alone repeat those calculations over and over again for each stock as it rises. They would much rather spend the time doing research, screening stocks in search of good set-ups, or planning trade strategy. That’s the beauty of Stops. With Stops, you can get the more sophisticated stop loss calculations without knowing how to write formulas and without learning arcane program syntax. You simply enter date and price data and Stops will do the rest based on the simple instructions you give it. Stops provides nineteen different ways to compute a stop loss and each of these can be infinitely tweaked to conform to your own tolerance for risk and investment time-frame.
Most successful traders prefer to place their stop loss just below a recent minor low. A minor low suggests that there is support at that level. They also prefer to place a stop loss under a significant trendline. However, there are times when the trader can find no recent minor lows or trendlines to use as a reference for placing the stop loss. At such times, a "mathematical stop loss" can be very useful. Stops can make computations that are based on statistical probabilities. For example, in a normally distributed population, measurements that are 2 standard deviations above the average (you don’t have to know what this means) occur about 2% of the time. That is, in any random sampling of 100 people, the probability is that 2 of them will score at that level (whether it is height, weight, IQ, strength, or whatever). Similarly, 2.5 standard deviations represent a frequency of occurrence of about 6 times out of 1000, and 3 standard deviations represent a frequency of 1.3 times out of 1000.
Apply the same concept to stocks. We can use measurements of dispersion like the standard deviation in our equations so that the stop losses generated will automatically adjust to the changing volatility of a stock. Thus, by applying the appropriate multiplier to the standard deviation portion of the equation, a person can set the stop loss so that it is unlikely to be triggered because of the normal volatility of the stock within 50 days, 100 days, or whatever.
However the market does not exhibit perfect symmetry in the dispersion of price behavior (you do not have to know what this means either, just follow along with us). Therefore, a perfect calculation of probable price excursions is not possible. Nevertheless, for practical purposes, the infinite range of adjustment possible with this tool renders such issues moot. Measurements of dispersion such as the standard deviation are the most useful tools available for making such calculations. They can indeed be used effectively to set stop losses that have a low probability of being triggered by most random spikes in the stock’s normal price behavior. Stops has a Multiplier by which you can adjust the weight that will be given to the standard deviation or other volatility measurement when the stop loss is computed. This tool can be used to find optimum stop losses. The key is to use a stop loss that is as close as possible to the current price (to minimize loss if the stock suddenly plunges) but that is not so close that it is likely to be triggered by normal volatility over the expected holding period of the position (to avoid unnecessary selling). When a stop loss is triggered, it should be for a good reason. There will always be some occasions when a stock will have a downward spike, trigger any reasonable stop loss, then climb to a much higher level. It is impossible to completely eliminate such occurrences. Though they cannot be eliminated, they can be made far less likely. Stops is a flexible and easy-to-use tool for generating stop losses shaped by the user to meet his or her own trading needs. For example, in one approach Stops uses algorithms that compute two preliminary stop losses and then it automatically uses the results of these computations in a subsequent set of computations. More specifically, it computes a preliminary volatility-adjusted stop loss and a preliminary percentage-based stop loss. The user can customize each. Then the results of the two approaches are given varying weights as selected by the user. Finally, these weighted values are automatically used as inputs in generating the final stop loss output. The user needs to make only a few simple settings and the rest is done automatically. In the example above, the volatility stop loss computation used is similar to the one Thomas Bulkowski uses and claims to have thoroughly tested (Bulkowski describes his approach in the September 2006 issue of Technical Analysis of Stocks and Commodities). This stop loss is based on a formula in Perry Kaufman’s book A Short Course In Technical Trading. Both Kaufman and Bulkowski are highly respected among traders and their books are widely used as references. Bulkowski’s favorite approach is to multiply the average daily price range by 2 in his formula. Rather than limiting you to a multiplier of 2, the Multiplier function in Stops gives you unlimited control of this variable. Stops also makes use of formulas derived from the work of Cynthia Kase.
A few other modifications were made in Stops to adjust for the fact that users often have no historical data for dates before the date of purchase. The algorithms in Stops can adapt to the volatility data as it accumulates and give this data increasing weight as the number of measurements increases. However, if you want to use a volatility-based stop loss using more data right away, you can click on the "Google Data" on the Home page to get historical daily stock data. Once the necessary data is entered or into the Stops spreadsheet, Stops will use the data to compute a volatility-adjusted stop. .
The Stop-Lab So you can get a "feel" for how various settings affect the stop loss, we have provided a Stop-Lab where you can experiment to find the settings that best suit you and your investment strategy. We suggest that you spend a little time conducting experiments here with a variety of stop loss settings before you use Stops to track real positions. Your tolerance for risk and your preferred investment time-horizon will have a big impact on the settings you use. In the Stop-Lab you can see the changes occur in your stop loss placement as you experiment with the settings. For example, if your goal is to capture most of a 1-month move (often a period of rapid acceleration), your stop losses will be much closer to the current stock price than if your goal is to capture most of a 6-month move. The potentially much greater returns of shorter-term investing come at the cost of greater trading activity, lower tolerance for risk, and a greater need for vigilance. Longer-term investing will generally require less trading activity (stop losses are triggered less frequently because more downside fluctuation is tolerated). The trade-off in using this more "relaxed" approach is the likelihood of a smaller return.For the purpose of conducting stop loss experiments in the Stop-Lab we searched for a stock with sufficient twists, turns, and trends to enable you to evaluate different combinations of settings. The Stop-Lab begins on row 1051 of the spreadsheet (Stops has internal links that instantly take you from one position to another or to the Stop-Lab). You can see more than 5½ years of charted price action by scrolling to the right. Because of the chart’s width, the prices would not normally be visible when you are looking at the middle and far right sections of the chart. The Users Guide explains how to "freeze" the prices on the left side of the chart so they are always visible. The calculated stop-loss is traced in red. From any theoretical "buy" point, trace the progress of the red line relative to the price action of the stock. The stop loss will be triggered whenever the stock’s low price falls below the highest price reached by the red line since the theoretical purchase. To avoid having a position sold because of an intra-day spike, some investors use "mental stop losses." They wait to see if the closing price is below the stop loss line because they believe that where a stock closes is more important than what it does during the day. You can study how your settings influence end-of-day stop losses by simply noting whether the stock’s closing price on the day of a decline is below the highest point reached by the red line. Why spend over a $1000 for a program that will calculate stop losses (if you can write the equations) plus a few hundred dollars in annual fees to pay for "support" (but probably not support in writing those equations)? With Stops, if you need help with your set-up or with spreadsheet procedures, simply call and ask for it. If you have a problem with Stops that we cannot solve over the phone, you can send Stops back to us as an attachment to an e-mail in which you summarize the problem. We will attempt to return it to you with the problem solved and your data preserved. Support is provided free of charge by people whose native language is English (sorry, we speak no other language). Please call during our normal office hours. If you call when we are away, you will have to call again or arrange by e-mail to call at a certain time. We do not return calls. While we will not accept collect calls, we will talk to you without charging you for the "privilege."
The Cost The use of Stops for a year costs much less than the price of a subscription to the average stock market newsletter. The average market letter consists of 8 to 12 pages of opinion. On January 22, 2001, Money reported on a survey it made of 61 market letters. The average annual subscription price for these newsletters was $220.46. Stops also costs considerably less than one adult would have to pay for one day at Disneyland. You can use Stops for an entire year for $75 (support included). Read the License Agreement for details before sending any money. Better stop loss placements throughout the year can easily translate into far more in profits and savings than the price of using Stops. Even one well-placed stop loss might save far more than the fee for a year. To read the License Agreement, click AGREEMENT. To order, click ORDER.
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