This is the final installment in our series of articles about placing protective stops.
3. Volatility Based Stops
A third method used to determine an initial protective stop is through the measurement of a stock's market volatility. A stock's current volatility is measured and then the initial protective stop is set just outside the price range defined by the volatility. By doing this, a trader will avoid getting stopped out due to a stock's trading within its normal volatility range. For example, if a particular stock had an average intra-day trading range of five points, it wouldn't be a very good idea to place an initial protective stop two or three points below the current price. This is because the probability would be high that the position would be stopped out due to market fluctuation that is "normal" for that particular stock.
There are a couple of ways Volatility Based Stops can be determined through the calculation and use of Average True Range (ATR) and Historical Volatility (HV).
Average True Range (ATR)
Legendary technician Welles Wilder developed the concept of Average True Range in his book, New Concepts in Technical Trading Systems, and it has since been used as a component of numerous indicators and trading systems. Volatile markets often gap higher or lower one day to the next and True Range takes this volatility into account in its calculation. True Range is the greatest absolute value of:
1. The distance from today's high to today's low
2. The distance from yesterday's close to today's high
3. The distance from yesterday's close to today's low
The Average True Range is a moving average (typically 14 days) of the True Ranges. By averaging True Range over time, a better feel for volatility is realized. Once you calculate the ATR for the time interval you are interested in, you take a multiple of the ATR and subtract it from the current closing price for a long position or add it to the current closing price for a short position. Usually, short-term traders will calculate the ATR over several trading days to a week and use a multiple of 1.0 to 1.5. Intermediate-term or longer-term traders will use an ATR over several weeks with a multiple of at least 2.0.
For example, let's say stock MSFT has a 14 day ATR of three points and we want to trade with a longer term trend in mind, so we choose to use a multiple of 2.0. We would then multiply the ATR of 3 by 2 to yield a value of
6. We would then subtract a value of 6 from the current closing price of MSFT for our initial protective stop for a long position and would add six to the closing price for a stop with a short position.
Historical Volatility (HV)
Historical Volatility (HV) measures the actual volatility of a security's price using a standard deviation based formula. Usually, HV is based on a one standard deviation move that suggests statistically that a security will trade within this one standard deviation range 66% of the time, assuming a normal distribution and present volatility. HV shows how volatile prices have been over the last "X" number of time
periods. The advantage of historical volatility is that it can be calculated using readily available historical security prices.
A computer does the calculating of HV, as it is too laborious to calculate by hand. One way to calculate HV is to use the following formula:
If T = time interval or length of volatility to be calculated
And NL = natural logarithm
Then HV(T) = standard deviation (NL (closing price/yesterday's close), T) * 100 * Square Root (256). The value of 256 is used because there are approximately 256 trading days in a year.
Larry Connors in his book Connors on Advanced Trading Strategies states that HV can be used to calculate stops as follows:
1. Divide 265 trading days by the number of days you intend to hold a position
2. Take the square root of the resulting number in step #1
3. Divide the HV by the resulting number calculated in step #2
4. Take the stock price and subtract the resulting number in step #3 from it for a long position and add the number to the stock price for a short position.
The advantage of using Volatility Based Stops is that they take into account the "normal" fluctuations or "noise" of a stock's market enabling a stop to be placed just outside the "noise" level, thus reducing the likelihood of being stopped out. The disadvantage is that Volatility Based Stops can often end up being quite large as in our recent trade of the very volatile Aether Systems (AETH) where we had about a 20 point wide stop.
Summary
We have briefly presented three different methods for calculating protective stops. Which method is the best one to use? It depends on the type of trading you do or your trading "style" and also on how much risk you are willing to assume. If you are a daytrader or very short-term trader, you will most likely make use of Dollar Based Stops to keep losses at a minimum and will risk enduring numerous smaller losses until a large winning position presents itself. Longer-term traders will make more use of Pattern Based and Volatility Based Stops to help reduce being stopped out by "market noise." Pattern Based Stops to some extent make use of market volatility as part of the technical analysis they are based upon. Both Pattern Based and Volatility Based Stops have the advantage of reducing the chances of getting stopped out with the added cost of assuming more risk.
Please remember that using any one of these methods is not an exact science. Also, you can use these methods in combination with one another. For example, if you are uncomfortable with the width of a particular Pattern or Volatility Based Stop, you could reduce the size of your trade to decrease the dollars at risk. If you're a short-term trader using Dollar Based Stops, you could also incorporate the Pattern and Volatility methods using smaller intra-day patterns and time intervals.
We hope you found this series informative and also hope it answered most of your questions concerning the determination and use of protective stops. Remember, you should always make use of an initial protective stop with every trade you place.
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