Use a Volatility Based or Volatility Adjusted Stop Loss
Stops calculates stop-loss settings using 19 methods, relative to recent high, low, or close.
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Use Stop Loss Orders to Limit Your Losses--and Let Your Profits Run!
There is no question that the habitual use of well-placed stop-loss orders will tend to keep losses small when stocks plunge (you may substitute "drop," "fall," "decline," or any term that means "asset loss"). In order to minimize the risk of substantial loss if the worst scenario occurs, the most successful traders/investors always place a "stop loss" order. That is, they instruct the broker to sell if the price drops to a specific lower price. Use of a stop loss enables a person to be on a fishing trip or to be 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 whole point of the stop loss is to automatically sell the stock if it drops to the specified price, and hopefully, before it drops any more. The exception to this is the trader who uses "mental" stop losses. We will discuss this stop loss later.
An example of a "stop loss" order is if a person says to the broker "I want to place a sell stop order for 100 shares of XYZ at $X." The term "stop loss" can be used instead of the term "sell stop." The broker understands that when a person says "stop-loss," it is really "sell stop" that is meant ("sell stop" is the more technically accurate term). The stop loss order either stays in effect for a certain period of time or it is "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 do you know where to place the stop loss order?
For example, during the 7 days after Dell’s stock gapped up on 10/29/07, the stock’s pattern showed probable short-term support at $29.40. A trader might place his stop-loss order at $28.25 (a long-term investor would place it lower). On 11/07/07 the stock dropped to $29.17. This move would have triggered an automatic sell order "at the market" as the stock's price passed through $28.25. The stock continued to drop. On 2/7/08 its low price was $18.87. This stop loss order would have protected the trader from a further decline of over 33%.
However, the stop loss order placed at $28.25 may not have actually been executed at that price. It became a "market order" when the stock fell to that price. The order would therefore have been executed at the best price available for the next transaction. That means the stop loss could be executed at a higher or lower price than the price at which the stop loss order is set. The stock could even gap down from above to well below the price set by your stop loss order. Even if that happens and your stop loss is triggered, it is probably a good thing to be rid of the stock because it’s likely that it is in real trouble.
In setting your stop loss, remember to ask yourself how much of your entire portfolio you are willing to lose on each position and plan accordingly. If you have 15 positions, a stop loss of 15% will cause a portfolio loss of 1% if the stop loss is triggered. On the other hand, if you have only one position, that stop loss will cause the portfolio to lose 15% if it is triggered.
Look at your purchase from a practical perspective.
Stop losses based on volatility or definable support are less likely to be triggered by random price movements.
Use a trailing stop loss strategy.
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 announced 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.
Before we go any further, let's review a few key points.
In most Web-site discussions of the stop loss, you will probably not find comments about specific percentages to use in determining where to place the stop loss. That’s because there is no magic number. The numbers we have used in this discussion are not necessarily recommended or the "best." They were chosen simply to illustrate and carry on the discussion. All stop losses will result in unnecessary selling (at a loss) at times. This is simply a part of the trading/investing experience that cannot be avoided. The closer the stop loss is to the price of the stock, the more likely it will be triggered (but the more gain you might lock in). The greater the distance of the stop loss from the price of the stock, the less likely that it will be triggered (but the more you are likely to lose on a significant decline). It all comes down to a balancing of risk against reward. You must determine your stop loss comfort zone for yourself. Some will feel most comfortable with a stop loss set at 2% while others are more comfortable with a stop loss of 15%.
Psychologists have measured the dispersion of the frequency distribution of I.Q. scores in a population. They call this measurement the standard deviation. On the Stanford Binet intelligence scale, the standard deviation is 16 points. Thus, the "normal" range is plus or minus 16 points from the average. Since the center of "normal" is defined as 100, for this I.Q. test, a "normal" I.Q. will fall in the range between 84 and 116. Only 2% (2 people out of 100) have an I.Q. that is 2 standard deviations above average, or 132. The greater the number of standard deviations a person scores above 100, the more rare his score is. So, a person with an I.Q. of 148 (a score that is 3 standard deviations above 100) would occur about once in a room of 1000 randomly distributed people. Similarly, if a person could measure the dispersion of the frequency distribution of stock price spikes from the norm, he could adjust his stop loss accordingly. For example, if he wanted to place it so that there would be only 1 chance in 50 that it would be triggered, he would place it 2 standard deviations from the norm. That is, he would apply a multiplier (the number "2" in this illustration) to the standard deviation measurement. If SD is one standard deviation, then 1 x SD would be subtracted freom the high low or close to have a stop loss with approximately a 16% probability of being triggered by random fluctuation. At the low minus 2 x SD, the odds of the stop loss being triggered by random fluctuation would be approximately 2%.
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