Volatility Stop Losses Protect Best
Use Stop Loss Orders to Limit Your Losses–and Let Your Profits Run!
There is no question that the habitual use of well-placed stop-loss orders will tend to keep losses small when stocks plunge (you may substitute “drop,” “fall,” “decline,” or any term that means “asset loss”). In order to minimize the risk of substantial loss if the worst scenario occurs, the most successful traders/investors always place a “stop loss” order. That is, they instruct the broker to sell if the price drops to a specific lower price. Use of a stop loss enables a person to be on a fishing trip or to be otherwise occupied, and if the stock falls more than it “should,” it is sold. When the stock declines to the stop price, the order changes to a “sell-at-the-market” order, and the stock is immediately sold at whatever the current market price is. The whole point of the stop loss is to automatically sell the stock if it drops to the specified price, and hopefully, before it drops any more. The exception to this is the trader who uses “mental” stop losses. We will discuss this stop loss later.
An example of a “stop loss” order is if a person says to the broker “I want to place a sell stop order for 100 shares of XYZ at $X.” The term “stop loss” can be used instead of the term “sell stop.” The broker understands that when a person says “stop-loss,” it is really “sell stop” that is meant (“sell stop” is the more technically accurate term). The stop loss order either stays in effect for a certain period of time or it is “Good-Till-Canceled.” Stop loss “At-the-market” orders are usually preferred over “limit” orders because a limit order can result in your not selling at all. That is, for a “limit” order to be executed, the stock would have to be at the “limit” price. When a stock is falling rapidly, it is generally better to get out than to quibble over price.
How do you know where to place the stop loss order?
Traders and investors will usually want their orders to be activated somewhat below a price where the stock is likely to get support. For example, if the stock “bounces” every time it drops to $47, that means there is support at $47. Therefore, an experienced investor will place his stop loss below $47, because it will take an unusual amount of selling pressure to break through that support and trigger the stop loss. Here’s another example. If the stock is trading at $50, is in a rising trend, and the trendline defining its rise is currently at $48 (trendlines represent support), a trader might place the stop loss at $47. Stop losses may be based on where demand (support) exists for the stock, on a drop that is more than can be accounted for by the normal fluctuations or volatility of the stock, or on a certain percentage drop. Of the three, experienced traders generally consider the first and second to be most effective. The market does not “care” about percentages or what you pay for a stock. A drop of X% below your purchase price “means” nothing to the market. The market tends to pay much more attention to its own patterns.
For example, during the 7 days after Dell’s stock gapped up on 10/29/07, the stock’s pattern showed probable short-term support at $29.40. A trader might place his stop-loss order at $28.25 (a long-term investor would place it lower). On 11/07/07 the stock dropped to $29.17. This move would have triggered an automatic sell order “at the market” as the stock’s price passed through $28.25. The stock continued to drop. On 2/7/08 its low price was $18.87. This stop loss order would have protected the trader from a further decline of over 33%.
However, the stop loss order placed at $28.25 may not have actually been executed at that price. It became a “market order” when the stock fell to that price. The order would therefore have been executed at the best price available for the next transaction. That means the stop loss could be executed at a higher or lower price than the price at which the stop loss order is set. The stock could even gap down from above to well below the price set by your stop loss order. Even if that happens and your stop loss is triggered, it is probably a good thing to be rid of the stock because it’s likely that it is in real trouble.
In setting your stop loss, remember to ask yourself how much of your entire portfolio you are willing to lose on each position and plan accordingly. If you have 15 positions, a stop loss of 15% will cause a portfolio loss of 1% if the stop loss is triggered. On the other hand, if you have only one position, that stop loss will cause the portfolio to lose 15% if it is triggered.
Look at your purchase from a practical perspective.
If you buy a stock that is 15% above its support, then a stop loss placed 8% below the purchase price is a meaningless stop loss. Trending stocks tend to revisit the rising support levels represented by the trendline. Hence your 8% stop loss will likely be triggered without anything significant having happened. If, on the other hand, you buy when the stock is only 1% to 2% above support, your 8% stop loss will not be triggered unless the stock falls enough to penetrate all the support just above your stop loss (in this case that’s a penetration of 6% or more, and it is not easy to plunge through that much support). That support represents buyers. If there is sufficient selling to overwhelm all the buyers 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.
Stop losses based on volatility or definable support are less likely to be triggered by random price movements.
Some will use the ATR (average true range) in calculating the stop-loss, but we will not go into that right now (our StopsXL tool has that computation already built-in). Others will base their stop-loss on the 20-day (or 4-week) low. Their thinking 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 stop loss just below that low. 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 place their stop loss 3% below the current value of the trendline if closing prices are used and the stop loss 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 stop loss a little more than 6% below the current value of the trendline. The greater distance of the stop loss is to compensate for the fact that there are often intra-day spikes that could unnecessarily trigger the stop-loss. 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.
Use a trailing stop loss strategy.
Here, as long as the stock is rising along a rising trendline, the stop-loss is adjusted upward on a daily basis. When the stock runs out of steam and begins to decline, the stop loss is triggered and a good portion of the gain is preserved. However, we have said that there are times when the pattern of a rising stock shows no support regions to aid in the placement of a stop loss order. If there are no trendlines that can be drawn and no other obvious support lines, that’s when many traders measure the volatility of the stock to determine the maximum range of excursion likely for the stock over a given time. Then they set their stop-loss just beyond the limits of the stock’s probable excursion. This is a volatility-adjusted stop loss. Here, the stock’s normal fluctuations are not likely to trigger the stop loss. Such an event is, by definition, improbable. However, any event or news that causes the stock to plunge or to drop an unusual amount would trigger the stop loss.
For example, on 1/3/08 support for Valero (VLO) was at about $68.05. During the following 20 days, the stock dropped to $47.80. If a volatility based stop loss order were used, it could reasonably have been placed at about $67.75. Such a stop would have saved the investor from having a loss of more than 29%. The stop loss would have triggered an automatic sell order “at the market” when the stock fell to $67.75. The stock did hit that price, and then it continued to drop. It must be acknowledged, though, that even if the stop loss were placed at $67.75, the stock may not have been sold at that price. Remember that the stop loss becomes a “market order” when the stock falls to the trigger price. The order would then be executed at the best price available for the next transaction. A frightening news item might be announced that causes the stock to gap down from above to well below the price of your stop loss order. If that happens, your stock will be sold at the next available price below the gap.
Before we go any further, let’s review a few key points.
Stop-loss orders are like the safety lines used by mountain climbers. The most common type of stop-loss is an order to sell “at the market” if the stock falls to a certain price. At the time you make your purchase, you are confident the stock is going to rise. Everyone makes mistakes. A stop-loss is your safety line or back-up risk-control system. Professional traders differ in the specific tools they prefer to use. However, nearly all of the top traders and investors include the stop-loss as an integral part of their strategies. Proper use of the stop loss is one type of discipline that can help a person limit his losses on any decline while letting profits run (by following the stock up with ever higher stop losses). A trader who does not use a stop-loss is like a circus high-wire performer who abandons the use of a safety net. If you are that kind of trader, 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). The more successful traders employ a stop-loss that rises along with the stock. A volatility-adjusted stop-loss is superior to one that is based on a drop of some specified percentage. The latter has a certain implicit rigidity that often causes unnecessary selling and unnecessary loss. A volatility-adjusted approach is more nimble as it automatically adapts to the statistically determined variance in the behavior of the stock.
In most Web-site discussions of the stop loss, you will probably not find comments about specific percentages to use in determining where to place the stop loss. That’s because there is no magic number. The numbers we have used in this discussion are not necessarily recommended or the “best.” They were chosen simply to illustrate and carry on the discussion. All stop losses will result in unnecessary selling (at a loss) at times. This is simply a part of the trading/investing experience that cannot be avoided. The closer the stop loss is to the price of the stock, the more likely it will be triggered (but the more gain you might lock in). The greater the distance of the stop loss from the price of the stock, the less likely that it will be triggered (but the more you are likely to lose on a significant decline). It all comes down to a balancing of risk against reward. You must determine your stop loss comfort zone for yourself. Some will feel most comfortable with a stop loss set at 2% while others are more comfortable with a stop loss of 15%.
More about volatility measurements. There are numerous ways to calculate volatility and the probable range of price excursion. The most common method used by statisticians is by calculating the standard deviation. The following illustration is meant to clarify the basic concept, so please be patient.
Psychologists have measured the dispersion of the frequency distribution of I.Q. scores in a population. They call this measurement the standard deviation. On the Stanford Binet intelligence scale, the standard deviation is 16 points. Thus, the “normal” range is plus or minus 16 points from the average. Since the center of “normal” is defined as 100, for this I.Q. test, a “normal” I.Q. will fall in the range between 84 and 116. Only 2% (2 people out of 100) have an I.Q. that is 2 standard deviations above average, or 132. The greater the number of standard deviations a person scores above 100, the more rare his score is. So, a person with an I.Q. of 148 (a score that is 3 standard deviations above 100) would occur about once in a room of 1000 randomly distributed people. Similarly, if a person could measure the dispersion of the frequency distribution of stock price spikes from the norm, he could adjust his stop loss accordingly. For example, if he wanted to place it so that there would be only 1 chance in 50 that it would be triggered, he would place it 2 standard deviations from the norm. That is, he would apply a multiplier (the number “2” in this illustration) to the standard deviation measurement. If SD is one standard deviation, then 1 x SD would be subtracted from the high low or close to have a stop loss with approximately a 16% probability of being triggered by random fluctuation. At the low minus 2 x SD, the odds of the stop loss being triggered by random fluctuation would be approximately 2%.
We have created a tool for investors that enables them to use sophisticated stop losses without having to perform the calculations. We call this tool StopsXL.
For information about our stop-loss calculator click on Stops