Active traders survive because they use initial stop loss protection as well as trailing stops to break even or to lock in profits. Many traders spend hours perfecting what they consider to be the perfect entry point, but few spend the same amount of time creating a sound exit point. This creates a situation where traders are right about the market's direction, but fail to participate in any huge gains because their trailing stop was hit before the market rallied or broke in their direction. These stops are usually hit prematurely because the trader usually places it according to a chart formation or a dollar amount.
The purpose of this article is to introduce the reader to the concept of placing a stop according to the market's volatility. In the past Investopedia.com has covered the topic of using a volatility stop based on the average true range (ATR). This article will compare the ATR stop to other volatility stops based on the highest high, the market's swing and a Gann angle. (For a primer on the ATR, refer to our article: Measure Volatility With Average True Range.)
The three keys to developing a sound exit methodology are to determine which volatility indicator to use for proper stop placement, why the stop should be placed this way and how this particular volatility stop works. This article will also show an example of a trade where volatility stops maximized profits. Finally, to keep the article balanced I will discuss the advantages and disadvantages of the various types of stops.
There are essentially two types of stop orders. The initial stop and the trailing stop. The initial stop order is placed immediately after the entry order is executed. This initial stop is usually placed under or over a price level that if violated would negate the purpose of being in the trade. For example, if a buy order is executed because the closing price was over a moving average then the initial stop is usually placed in reference to the moving average. In this example, the initial stop may be placed at a predetermined point under the moving average. Another example would be entering a trade when the market crossed a swing top and placing the initial stop under the last swing bottom or buying on an uptrend line with an initial stop under the trend line. In each case the initial stop is related to the entry signal.
A trailing stop is usually placed after the market moves in the direction of your trade. Using the moving average as an example, a trailing stop would follow under the moving average as the original entry appreciated in value. For a long position based on the swing chart entry, the trailing stop would be placed under each subsequent higher bottom. Finally, if the buy signal was generated on an uptrend line then a trailing stop would follow the trend line up at a point under the trend line.
Determining a Stop
In each example the stop was placed at a price based on a predetermined amount under a reference point (i.e. moving average, swing and trend line). The logic behind the stop is that if the reference point is violated by a predetermined amount then the original reason the trade was executed in the first place has been violated. The predetermined point is usually decided by extensive back-testing.
Stops placed in this manner usually lead to better trading results because, at a minimum, they are placed in a logical manner. Some traders enter positions then place stops based on specific dollar amounts. For example, they go long a market and place a stop at a fixed dollar amount under the entry. This type of stop is usually hit most often because there is no logic behind it. The trader is basing the stop on a dollar amount which may have nothing to do with the entry. Some traders feel this is the best way to keep losses at a consistent level but in reality it results in stops getting hit more frequently.
If you study a market close enough, you should be able to observe that each market has its own unique volatility. In other words, it has normal measurable movement. This movement can be with the trend or against the trend. Most often it is used in reference to moves that are against the trend. This movement is referred to as a market's noise. The best trading systems respect the noise, and the best stops are placed outside of the noise. One of the best methods of determining a market's noise is to study a market's volatility.
What to Expect
Volatility is basically the amount of movement to expect from a market over a certain period of time. One of the best measures of volatility for traders to use is the average true range (ATR). A volatility stop takes a multiple of the ATR, adds or subtracts it from the close, and places the stop at this price. The stop can only move higher during uptrends, lower during downtrends or sideways. Once the trailing stop has been established, it should never be moved to a worse position. The logic behind the stop is that the trader accepts the fact that the market will have noise against the trend, but by multiplying this noise as measured by the ATR by a factor of, for example, two or three and adding or subtracting it from the close, the stop will be kept out of the noise. By completing this step, the trader may be able to maintain his/her position longer, thereby, giving the trade a better chance of success.
Other types of stops based on the volatility of the market are stops which are calculated in reference to the highest high or lowest low over a fixed time period, a swing chart which allows the market to move up and down inside of a trend, and a Gann angle which moves at a uniform rate of speed in the direction of the trend. (To learn more about Gann angles, take a look at our article: How To Use Gann Indicators.)
When working with volatility stops, one has to clearly define the objectives of the trading strategy. Each volatility indicator has its own characteristics especially regarding the amount of open profit that is given back in an effort to stay with the trend.
Figure 1: 2009 May Soybeans
Source: TradeStation, 2009.
This chart shows how various stops would be applied to a short position. There are four types of trailing stops used in this example. The Highest High of the last 20 days, the 20-Day Average True Range times 2 plus the High, the Swing Chart top and the downtrending Gann Angle.
Figure 2: Soybeans May 2009 w/ trailing volatility stops.
Source: TradeStation, 2009.
In Figure 2 the arrows indicate where each of the trailing volatility stops would have executed during the normal course of the trade.
Looking at the chart, one will observe that the Highest High of 20 days stop is the slowest moving trailing stop, and can give back the most open profits, but also allows the trader the best opportunity to capture most of the down trend.
The 20 Day ATR Stop times 2 + the High moves down as long as the market is making lower highs. This stop never moves up even if the top moves up. It remains at the lowest level reached during the decline. Because it never moves higher, it gives back less profit than the other trailing stops. The disadvantage of this stop is that it may be executed early in the trend, thus preventing participation in a larger down move.
The Swing Chart follows the trend of the market as defined by a series of lower tops and lower bottoms. As long as the current top is lower than the previous top, the trade remains active. Once a trend top is crossed, the trade is stopped out. This type of trailing volatility stop can give back large amounts of open profits depending on the size of the swings. The trade-off is that it may allow the trader to participate in a larger move. (For more on Swing charts, refer to Introduction to Swing Charting.)
The last trailing stop is the Gann angle stop. The Gann angles begin from the highest high immediately before the trade entry. The Gann angles in this example move down at a uniform rate of speed of four and eight cents per day. As the market moves down, the distance between the angles widens. This means that the trader may give back a large amount of open profits depending on which Gann angle is chosen as the reference point for the trailing stop. Furthermore, a trade may be stopped out prematurely if the incorrect angle is chosen.
The type of trading system that benefits most from a volatility stop is a trending system. The trader simply uses a trend indicator such as a moving average, trend line or swing chart to determine the trend then trails the open position using a volatility stop. This type of stop may be able to prevent whipsaws by keeping the stop outside of the noise. Highly volatile or directionless markets are the worst conditions under which to trade using a volatility stop. Under these conditions stops are likely to get hit frequently.
By nature, a trend trading system will always give back some of the open profits when used with a trailing stop. The only way to prevent this is to set profit targets. However, setting profit targets can limit the amount of gains on the trade. Some trailing stops based on volatility can prevent capturing a large trend if the stops are moved too frequently. Other volatility based trailing stops may "give back" too much of the open profits. Through study and experimentation with these various forms of trailing stops, one can optimize which stop best meets his or her trading objectives.
In addition, read Forget The Stop, You've Got Options to learn about other options for limiting losses.