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Volatility Based Adjusted Stop Loss
Volatility Adjusted or Volatility Based Stop Loss & No Math

Volatility Adjusted or Volatility Based Stop Loss & No Math


The calculator described below on this page is no longer available (see black text).  However, a stop loss calculator based on Welles Wilder's Average True Range (ATR) is still available.  It uses the same procedures and formulas used in the same way Wilder used them.  Some ATR calculators do not correctly use Wilder's original concept.  For example, they sometimes compute the True Range by using a simple moving average of a stock's daily range or 2-day range.  Sometimes, they compute the Average True Range differently.  In other words, they derive stop losses that differ from those of Wilder.  Our stop loss calculator generates the same numbers that were generated by Wilder's original methodology.   For more on this, go to Stop Losses 

Stop losses based on volatility measurements are much less likely to be triggered by a random fluctuation in price. Most expert traders and investors will use direct measures of a stock's volatility, such as the standard deviation and the ATR (the Average True Range) in placing their stop losses.  We provide a means by which you can use standard deviations and other measurements of volatility without having to perform the calculations. 

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.

The Stops layout is illustrated here.  You must have Excel 2007 or later with macros enabled to use the program. 

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.

It is important to factor in the volatility of the stock when determining 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.

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.

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, investors 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.

Most successful investors 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 function 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.  The formulas for ATR (Average True Range) based stop losses are a little different from those used by Wilder.  In Stops, the high-low range for two days is used in computing True Range (a method used by many experienced traders).  Our other program, ATR Stops, uses Wilder's equations.  It was designed for those who prefer ATR-based stop losses and who want a more "pure" implementation of Wilder's approach to computing the ATR. 

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. 

Additional details have been removed because the program is not available.

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Stop Loss Related Information On This Site

Stop Loss "Psych-Outs" Stop Losses and the 4-week Rule
Stop Losses and Probabilities Stop Losses and Risk Control
Stop Loss Relation to Diversification Stop Loss Long-Term
Stop Losses Getting Triggered Stop Losses and "Normal Fluctuation"
Stop Loss Information Stop Loss Tool



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