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Use a Volatility Based or Volatility Adjusted Stop Loss
Volatility based or volatility adjusted stop loss placement strategies & systems can reduce the frequency of premature and unnecessary sales. How do you set a stop loss so the stock can wiggle as it rises? Volatility adjusting methods & procedures enable you to do that. We think they are the best choice when there are no obvious regions of support to use as a reference. They are far better than using a straight percentage (where you're guessing and probably inviting more loss than necessary or causing an unnecessary sale) or simply "eyeballing" a chart. They can allow just enough "wiggle room" so the stop won't be triggered by normal "noise" as the stock works its way to higher price levels.
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Stop-loss orders function as a back door, a way of automatic escape from a "crash and burn" situation with minimal pain. The basic stop-loss is an order to sell the stock "at the market" if it hits a certain price. When you buy a stock, you are relatively sure it is about to rise. What if you are wrong? The stop-loss provides a good back-up risk-control system. Most professional traders use a variety of tools in their work. However, the stop loss is one tool that almost all successful traders and investors endorse. It is one of the best tools a person can use to limit losses while letting profits run. If you do not use a stop-loss, you are begging the market to teach you a lesson. If you’re not watching, or if your indicators leave you indecisive, you could lose most of the value of a position. If you're using margin, you could lose more than your entire investment.
Experienced traders make it a rule to always enter a stop-loss order whenever they take a position. That's because they have learned not to invest or trade without a "safety net." It is the way they draw a line in the sand and say "this much of a drop I can tolerate, but no more." Use of this tool enables a trader to be on a fishing trip or otherwise occupied and if the stock plunges or even if it falls more than it "should," once the stock hits the stop price, the order converts to a "sell-at-the-market" order and the stock is immediately sold at whatever the current market price is.
To place this kind of order with his broker, a trader might say "I would like a sell stop order for 286 shares of ABC at $X." "Sell stop" is the technically correct term. However, the broker knows that you really mean "sell stop" when you say "stop loss" so either expression is usually okay. The order is usually good for a limited time or it is "GTC" (Good-Till-Canceled). "At-the-market" orders are usually preferred over "limit" orders because a limit order can result in your not selling at all. Most people will want out of the position most of the time if the stop price is reached.
How does one determine where to put it? A stop-loss order can cause you to sell prematurely if you put it too close. On the other hand, if it is too far away, it will not offer much protection. Traders and investors will usually want their orders to be activated somewhat below a price where the stock is likely to get support. If the stock "bounces" every time it drops to $47, that means there is support at $47. A trendline is also a region of support. If a stock is in a rising trend, and the trendline defining its rise is at $39, a trader might set the his stop loss order at $38. A stop loss could also be based on a drop of a certain percentage or on a drop that is beyond the normal fluctuation range or volatility of the stock (we'll come back to this approach later). There is no knowledge in the market about where you buy a stock. The stock does not "care" what you paid or what percentage drop you think would be a good selling point. If a stock falls X% below your purchase price, it means absolutely nothing to the market. The market is much more interested in its own patterns.
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 released 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.
This page is merely an introduction to the subject of stop losses. The following blue link will take you to more detailed information. At the bottom of the next page is a group of links to ten pages that discuss various aspects of stop losses and their placement.
Click here for more on stop losses
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