Money

Volatility Stop Loss

One of the common ways to set an initial stop loss is to use a volatility method. The volatility method I consider uses a concept (also a technical indicator) called Average True Range (ATR). If you are not familiar with it, it would be best to read up on ATR, then come back here.

Using a volatility method, you are prepared after entry, for the price to fall a distance which is based on the volatility of that one stock (or how far it normally moves on a day to day basis).

Taking material from the ATR article – to use ATR for exits, you would normally use a multiple of the ATR to ensure a sufficient gap between your exit and the stock’s normal price movement. Therefore, using the ATR without any modification (the ATR value itself, eg. 5 cents) would have your stop loss too close to the price and would not allow the stock you are trading sufficient room to move and behave naturally.

Depending on your trading style, you would normally consider using something in the order of 2 – 3.5 multiplied by the ATR as a suitable initial stop loss. If you used what is referred to as a ‘2.5 ATR stop’, then your initial stop loss will be 2.5 multiplied by the ATR below your entry price.

As an example, we purchase XYZ Corporation at $2.20, and we use a 3ATR initial stop loss. The ATR is 5.4 cents.

We work out what the ATR multiplied by 3 is and then subtract that from the entry price.

Using the example detailed above, the exit price is calculated as follows:

Initial stop loss
= $2.20 – 3 x ATR
= $2.20 – 3 x $0.054
= $2.20 – $0.162 (round down to $0.16)
= $2.04

NB: Yes you could have rounded the $0.162 up to $0.17 however it is not worth discussing. Let me assure you that the 1 cent up for grabs won’t really matter in the long run.

So in the above example, our initial stop loss for our trade with an entry price of $2.20 would be $2.04.

Remember, the advantage of this method is that it considers the volatility of the stock you are purchasing and tailors the initial stop loss accordingly.

Of course, you can use any range of numbers, eg. 1.5ATR through to 4 – 5ATR. The items to consider are the same as using different percentages.

If you use a 1.5ATR initial stop loss, you are obviously not allowing your stock to fall as far before you consider it a loser and exit the trade at a loss. This can be a disadvantage as you are potentially not allowing your stock the freedom to move above normally and perhaps continue its medium term trend.

On the other side, if you use a 4ATR initial stop loss, you are providing the stock ample opportunity to move in your anticipated direction before you consider it a loser and exit the trade at a loss.

Let’s consider the 4ATR initial stop loss for a moment then – you might be reading this and think “but if I give back all that movement before I exit, I am going to lose more money!”

Fair comment – however it depends.

If you commit an equal amount of money to each trade, then yes, you are correct. Having your initial stop loss further away will result in a greater loss.

However, using a better position sizing model, ensures that regardless of how far your initial stop loss is away, you only lose the same amount of money. This is what money management is all about.

This method can be quite effective and you will naturally discover what multiple of the ATR is best for you. This is all there has to be with calculating an initial stop loss, if that is it, then it makes you wonder why more people don’t use it and cut their losses. Let me reiterate – one of the most important things you can do trading is to cut your losses.

“Learn to take losses. The most important thing in making money is not letting your losses get out of hand.”
Marty Schwartz