Volatility Adjusted or Volatility Based Stop Loss & No Math
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.
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. For example, 2 standard deviations below the highest high to lock in most of any upward surge. One strategy he could use is to keep raising the stop loss as the stock rises so that it 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.
Sample of a Stops Page
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.
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.
It is important to factor in the volatility of the stock when determinin where to place 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. Through our training programs we learned that most people do not know how to measure volatility. If they use stop losses at all, they tend to use a rather simplistic one that ignores 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. 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 orders to sell could add an extra 10% (and possibly a lot more) to the return of a portfolio. Traders need to be able to find the optimum selling point (for every stock for each day) 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. We are acquainted with one person who 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 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 showing 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.
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.
There are eleven convenient locations in Stops where you can enter the high and low prices of a move to have Stops calculate Fibonacci retracement levels (traders often make use of them in placing their stops). The bottom right corner of the above image shows part of one of these
Fibonacci calculators. 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 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. An alternative approach is to place it under a significant trendline. However, there are times when the trader can find no recent minor lows or trendlines to use as a reference. 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 number of standard deviations or other volatility measurement that will be used 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). His approach 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 indicated his 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 get data from Yahoo or Google. Instructions are given for collecting and arranging the data. Once the necessary data is entered into the Stops spreadsheet, Stops will use it to compute a volatility-adjusted stop.
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 charts 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. 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.
Stops works on Windows-based systems that have Microsoft's Excel (Excel 2007 or later). When you click on the Stops icon, Stops automatically opens in and makes use of your spreadsheet program. While Stops is easy to use, there is a lot to it internally. Consequently, it can take up to four minutes to load on some systems. Once it is loaded, data can be entered as quickly as for any simple Excel spreadsheet. That’s because it is configured so that it will not compute anything until you tell it to by tapping the f-9 key. Simply make all your entries, hit the f-9 key, and wait for Stops to complete its computations. We configure the program so you must hit the f-9 key before it calculates stop losses because otherwise Stops would recalculate over 50,000 thousand equations every time a new entry is made, even for the most minor changes (like entering a low price for one day). That would result in repeated and annoying wait times. Depending on the speed of your system, the recalculation can take 3 minutes (possibly a little longer). [Note: Some computers require the user to press the "fn" key while pressing the f-9 key.]
You must be able to open and use an Excel 2007 spreadsheet with macros (.xlsm files) on your computer to be able to use our stop loss calculators. To test your system, click on the following link. It will take you to a page where you can download a small Excel spreadsheet with a macro (Stops has a few macros). If you can enter a number and cause the macro to work and the spreadsheet to recalculate, then you should have no trouble using Stops on your system. This test spreadsheet is in .xlsm formatting. Go to the test page.
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 about as much as a 1-day adult ticket to Disneyland (currently a 1-day ticket is $92). The price for using Stops for 6 months is $95. 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, and the only way an order will be accepted is if a person follows our required procedure. The reason a different procedure is required for ordering Stops than for ordering our other products is because Stops is software that we e-mail to a person, while most of our other products consist of information that is available on this Web site by the use of a password.
If you wish to place an order, send us an e-mail to let us know. We will give you instructions on how to proceed. You can e-mail us from the "Contact Us" page. Our e-mail address is also on that page in case you want to e-mail us using your own e-mail program. If you do, use the phrase "Special Order" for the subject line so your message will not be deleted as spam.
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