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Volatility Stop Losses Protect Best
Use a Volatility Based or Volatility Adjusted Stop Loss

Use a Volatility Based or Volatility Adjusted Stop Loss

An Introduction

Volatility based or volatility adjusted stop losses can reduce the frequency of premature and unnecessary sales.  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.  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.  

The basic stop-loss is an order to sell the stock "at the market" if it drops to a certain price.  When you buy a stock, you are relatively sure it is about to rise.  What if you are wrong?  The use of a stop loss is endorsed by nearly all successful traders and investors.  It is one of the best tools a person can use to limit losses while letting profits run.  

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 a stop loss enables a trader to be on a fishing trip or 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 order is usually good for a limited time or it is "GTC" (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 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.  For example, 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 (because the stock tends to "bounce" off that line).  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).  The market does not "know" or "care" where you bought a stock.  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 of support and resistance.

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.

Volatility based stop-losses are placed just outside the probable excursion range of the stock so that it is not likely that the stock will be sold on most "normal" price lurches, but it will cut losses quickly on more significant declines.  We provide a means by which you can use standard deviations and other measurements of volatility without having to perform the calculations. We'll get to that later. 

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." There are times 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.  That is when 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 that.  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 a 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.  More commonly, they change the stop loss once a day after the market's close.  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 (don't worry about the definition of "standard deviation," just follow along with us). 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. 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. These stop losses are discussed in Technical Analysis of Stock Trends, by Edwards and Magee.  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.  However, there are situations where there are no obvious regions of support.   In those situations, ssome will use direct measures of a stock's volatility, such as the standard deviation, the ATR (the Average True Range), or some alternative measure of volatility in placing their stop losses. 

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.

This page is merely an introduction to the subject of stop losses.  

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