Saturday, November 08, 2008

Some Considerations for Setting Stops in High Volatility Markets

"I don't make jokes. I just watch the government and report the facts." Will Rogers

It is certainly no secret that the recent past has demonstrated a period of historically high volatility in the markets. One of my very successful coaching students from this past year wrote last weekend and suggested that I write an article dealing with setting stops in this high volatility environment. I agree that subject is something that might be helpful so what follows are some of my thoughts on the subject.

First I should say that a consistent mantra for me has been to have an exit strategy in place before ever entering a position. In that fashion, the exit decision is made out of the heat of battle when the trader can calmly decide on a disciplined approach to his exit. At the time of entry I believe the initial exit should be close to the entry and it should be clear. I personally define the clarity as some line on a chart. It could be defined by a trend line, a price support, a moving average, a MACD crossover, or any number of things that remove my emotion from the exit decision. If an exit is set in that fashion and adhered to, losses are essentially cut automatically. If I am wrong on direction I am out of the position with relatively little pain in most instances. That takes care of the clear part of the initial exit strategy. If I am right on direction, I may then follow the move by trailing stops or continuing to use the trend line as the exit (or one of a vast variety of other methods) in order to attempt to let my profits run.

The second part of my exit theory is that the initial exit should be close to the entry and that can be one of the most difficult things in trading. What is close for me may not be for you. You may be willing to risk a couple of dollars a share on a position and consider that amount to be "close" to your entry while I may define "close" as only 50 cents from my entry. This part of setting stops is one of the most subjective and difficult parts of successful trading in my book. One of the problems is that we don't want to be whipsawed out of a position. As an example, if we set our stop too close on a bullish play (like buying a stock), the price could dip, we would be stopped out of the position, and the stock could then turn back up and head north just as we supposed it might when we entered the play.

Setting stops, in my estimation, is probably more art than science and it is one of the reasons I advocate practice trading. Paper trade stop setting to see what works for you. In these volatile days, stocks have tended to move in a wider range both on a daily and on a weekly basis -- that's simply evidence of the volatility. The first thing I conclude from that wider range is that I need to change my definition of what is "close" during volatile times if I want to avoid being whipsawed out. How can this be done? Once again, it is subjective. A starting point may be to check out the daily range within which a stock trades. Placing a stop within that range may well result in getting taken out of the position just through the normal daily movement of the price. Recognizing that probability, we might want to be sure our stop is outside that range in an effort to avoid an exit occasioned by movements within the expected daily range. We might also consider looking at a weekly range to decide whether we want our stop within or just outside that range. The point is that we know the range for a day or a week is going to be wider when things are more volatile than they would be when volatility is reduced. That awareness can help us reach our own conclusions as to precisely where we might place a stop. In a less volatile market, stops may be closer and in a more volatile market they will be farther away if we expect to avoid the whipsaw.

I know of no hard and fast rule to set stops depending upon changes in volatility; I only know that as volatility increases we need to change our own approach. We simply can't expect to set the same stops in a volatile market as we would in a calm market and get the same results. This area is one in which I often spend a great deal of time with coaching students and which I have dealt directly in past seminars. It is one of the hardest yet most important subjects in attempting to arrive at high levels of success in trading. It is worth working with someone knowledgeable and practicing on your own because it can truly inflate your returns.

by Bill Kraft, Editor
Copyright 2008, Makin' Hay, Inc.
All Rights Reserved


P.S. Save $50 PER MONTH on my subscription trading newsletters!
SAVE on my Under $10 Stock Trader Service!
SAVE on my Option Trader Service!
SAVE on my Trend Trader Service!

Technorati tags:

To comment on Bill's article click on the "comments" link below.

14 comments:

jegan said...

Thanks for the article on setting stops and volatility. Very timely. Of course, no-one can complain about being stopped out as the market tanks anyway. I did read a suggestions that 2 times the ADR is a valid means of placing a stop if you are holding the stock for more that a very short period. I prefer 25 cents below the last pivot for cheap stocks and a bit more for more expensive stocks.

And liked your book. Time to re-read it..

jegan

ChuckS said...

It seems like knowing yor exit before entering a trade could help you decide to skip the trade if it has a lousy exit. One could even look for trades with good exits to choose from to minimize losses. This could be good for beginners.

What happens if the ADR of a stock would take it beyond a strong support/resistence? Would it usually stop at the support/resistance?

If you're right about the direction of a stock, would it tend to go less in the opposite direction than the ADR would indicate?

Chuck

jegan said...

i agree with chucks for the most part. These days with one day market swings in the 1000 point range, it's hard to know where an entry or exit.

I tend to use stochastics as the stock moves off a low and crosses the 20. I normally set my stop just below the 20. The downside is therefore very small and the upside depends on the volatility of your stock and period you are trading. If you chose a stock that channels, then figuring the upside is pretty clear. My exit is normally a move above the 80 and a turn down back through it.

jegan

Anonymous said...

I've been trading 100%of your buy recommendations for several months. Considering the monthly subscription cost, I am still trading at a minimal gain and and have several open trades at substantial losses. When you recommend a buy position why don't you also recommend a stop loss position. I assume that you have thoughly researced the stock prior to your recommendation and have protected yourself, but are we subscribers left to flounder when the recommendation heads south????

Jerry B said...

Bill,

Always look forward to your weekend newsletter. I need your knowledgable words to keep me grounded sometimes and stay on the correct path. Can you sometime in the future go over how to make adustments in credit and debit spreads. I didn't see any details of this in your book. Thanks.

Anonymous said...

Thank you for the article on exits and all your other week end musings. RE: the exits, it is difficult to set an exit when one's account is under the SEC's regulation of having $25,000 in the account to exit on the same day the trade is entered. Yes one can do it a couple of times a month, but as volatile as this market is you can do that in one day. I have been trying to trade during late afternoon on trends in the five to ten minute charts and hope they carry over to the next day. I have had some success with this. Can you write something along these lines if you feel there is some merit to it.

Tim said...

Bill,

Thanks for sharing your stop information.

Did you get enough response for your seminar early next year?

My wife and I are very interested. We would like to start planning a trip to the Southwest.
Thanks,
Tim
Tim

Anonymous said...

Obviously knowone at this site knows what they are doing including the author. Stops are a waste of time and $ when the VIX is this high. If you like giving away your $ listen to these goofy I ideas. If you want to protect a long position don't use stops. Buy puts. What do puts accomplish? First of all you don't get stopped out of a position when the market drops 1000 points in two days. Secondly you can make more $ on the puts then the long position. You sleep at night knowing position is protected. Cheap insurance!

Bill Kraft, MarketFN.com said...

Thanks jegan. As you suggest, there are many ways to set stops. I believe that doing it is more important than not and the method is often specific to the individual and the trade.
Bill Kraft

Bill Kraft, MarketFN.com said...

Thanks for writing, Chuck S. I have taught the concept of a close clear exit for many years. I sincerely believe it is not just for beginners, but that all traders would benefit from using the concept. If there isn't a nearby exit at the time of entry, the trader may well be setting himself up for a big loss. In terms of support and resistance, the "expectancy" is that the price will turn at those levels. That doesn't mean it will, only that we should be prepared for that eventuality no matter what the ADR may be. None of the tools is perfect, they are best used as guidelines in my view.
Bill Kraft

Bill Kraft, MarketFN.com said...

Thanks for writing, Anonymous, I'm glad to hear you have enjoyed a gain following my trades over the last difficult months. What service are you subscribing to? As I have often written, it is critical that you and any trader make their own decisions since your goals, risk tolerance, knowledge level, capital, and time you can devote to the market will be different than mine or anyone else's. You indicate that you assume that I have "thoroughly researched the stock" before making a trade. If you are referring to fundamentals as the language suggests you are, it is important for you to know that I am a technical trader, not a fundamental trader. I do that as I have often written because fundamentals don't tell us when to exit or when to enter. While I do look at fundamentals, my trading decisions are not made on that basis. With regard to stops, again as I have often written and said, they are very subjective and highly dependent upon the individual trader and his risk appreciation and tolerance. Some traders, myself included, may also use protective puts, described in great detail in "Trade Your Way to Wealth" as well as stops. The trades I present are examples of things I do and all traders must make their own decisions because the risk is always theirs.
Bill Kraft

Bill Kraft, MarketFN.com said...

That's a great point about intra-day trading, Anonymous. It is a huge problem in markets like what we have recently seen. As long as the account is below the minimum for day trading, the trader only has a couple of options to avoid pattern day trader status. He can avoid trading altogether during these times (which may not be a bad idea) and stay in cash, or he could strictly limit his trades so that he does not run afoul of the rule. Unfortunately, I am unaware of any other practical way to deal with the problem.
Bill Kraft

Bill Kraft, MarketFN.com said...

Tim, thanks for inquiring about the seminar. We are "on the cusp" with interest. Would you please call Earleen at the MarketFN number and get my phone number here in Arizona so I can discuss specifics with you? That goes for any potential students who are serious about the seminar.
Bill Kraft

Bill Kraft, MarketFN.com said...

To Anonymous who advocates buying puts. Obviously you haven't read my book, "Trade Your Way to Wealth" which deals in great detail with the importance and use of protective puts. They are yet another way to protect a position that I often use. Nevertheless, even in volatile markets a stop can be useful, certainly more useful than not using any protection. Believe it or not, there are many ways to protect positions and though yours is fine for you it is not for everyone.
Bill Kraft