Volatility Adjusted or Volatility Based Stop Loss & No Math
Volatility adjusted or volatility based stop-losses can give a stock just enough wiggle-room to avoid selling on most meaningless price lurches, but still cut losses quickly on significant declines. We provide a means by which you can use standard deviations and other measurements of volatility without having to perform the calculations.
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 sell 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 stock's 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 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 an unnecessary sale. 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 their trendline. That means your 10% sell order 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 immediately above your stop order. In this case that's a penetration of 8% or more, and it is not easy to decline that much through buying demand (support or buying demand can be identified by the existence of a trendline or region of consolidation). If the sellers can overwhelm all the buyers waiting to buy just above your sell order (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 should want your sell order to be executed, but it is not necessary for you to take an 10% loss in the process.
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 (check our Tutorial #24 for more on the volatility-adjusted stop loss). Thus our hypothetical trader might place his stop loss 2 standard deviations below the highest low, close, or high reached by the stock since its purchase. Two standard deviations below the highest high could be used to lock in most of any upward surge. For example, a person could keep raising the stop loss as the stock rises so that the stop is always 2 standard deviations 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 2 standard deviations 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. Some will use 1.5 standard deviations below the highest close or 1 standard deviation below the highest low, and so on. These traders have a shorter time horizon and are attempting to capture the gains from short-term surges in price (where the percentage gain is greater relative to the amount of time invested). The specifics of order placement are tied to the investment time horizon and the volatility of the stock. The trader must determine the kind 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 direct measures of a stock's volatility, such as the standard deviation, the ATR (the Average True Range), or some estimate of volatility in placing their stop losses. 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 can be closer, but if they are actually placed with a broker they could be triggered by an intraday spike.
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 take such protective measures, is like a circus high-wire performer who abandons the use of a safety net. He is asking for trouble. If you do not use a sell order "safety net," 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 (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 volatility-adjusted stops that rise along with the stock because that kind of stop loss automatically positions the sell order so that it is appropriate for the statistical variance in the behavior of the stock. Percentage stops cannot do that.
The Stops tool makes it easier 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 even a "lab" in the Stops tool (described below) where you can experiment with different tool settings. The Stops tool facilitates a disciplined approach to trading and investing. It helps eliminate emotion from the sell-decision.
The following image is a sample of a Stops page layout.
One problem traders and investors face is how much to let a stock decline before selling. Our tool addresses this issue. The ideal sell strategy will minimize the loss if the stock plummets but still give the stock room for normal fluctuations while it continues to climb. Correct sell order 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 generally necessary to use some math. The Stops tool makes the calculations automatic. Stops comes with a "Lab" in which you can experiment with different settings and see how changes in those settings change the stop loss. The lab has five charts, each with a red stop loss line. The line shows where the stop loss would be triggered based on the settings you have entered. This is described in more detail below, in the section titled "The Stop-Lab." With this tool sell orders 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 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, Kaufman, 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. In calculating the sell point, an individual is actually defining 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 sell order each time the stock ratchets up to a higher level.
The Stops Solution
Traders do not want to spend their time studying program syntax and non-intuitive procedures, and we have found no inexpensive easy-to-use tool we could recommend that will automatically do the math required to compute a sophisticated stop loss. So, we developed one. We 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. Stops includes a Stop-Lab where you can experiment with different settings and see the effect of those settings on 5 stock charts that show a variety of stock behavior patterns. 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.
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.
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.
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. We have not checked lately, but we are sure prices have gone up considerably since then. A simple cost of living adjustment through August of 2013 would increase the price to $290.48. Use of Stops for 6 months also costs less than a 1-day adult ticket to Disneyland (currently a 1-day ticket is $92). The price for using Stops for 6 months is $85. Better stop loss placements can easily translate into far more in profits and savings than the price of using Stops. Even one well-placed stop loss might save many times the cost for a year of use.
Ordering and The License Agreement
Read the License Agreement for details before ordering. To read the License Agreement, click on Agreement. An order cannot be transmitted to us unless you acknowledge that you have read the License Agreement. Click here to see a video demonstration of Stops
Previously, we did not offer a trial period because we could not turn the tool off remotely once we sent it to a user. We believe we have solved that problem. We can now program the tool to automatically shut down if new codes are not entered after a trial period. See the License Agreement (above link) for details about the trial period. If you are interested, click on summary and opportunity to order.
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