As a trading instructor, I sometimes catch myself muttering in my sleep, "Make sure you set your stop on that trade!" Ok, so I may not actually do that. But I am saying it constantly in the classes I teach. It is the main thing we as traders can do to help prevent catastrophic losses in our accounts. We must protect ourselves on every trade we take. There are no traders out there who win on every trade and the ones who are long-term profitable are consistent with their analysis of risk and protect their capital.
So how should we go about setting those stops? Well, part of preparing and planning your trade should encompass placing your stops in a technically sound spot. This should be a price where if you are stopped out, it is due to a change of trend and not because you were caught too close to the volatility of the stock itself. The volatility of a stock refers to the measure of the movement of price away from an average. A simple way of viewing this is by looking at the Average True Range.
True range is the difference between a stock's high and low for the period. Or, it is the absolute difference between the previous close and the high, or the previous close and the low, whichever is greater. The true range measures the distance a stock has moved, including any gaps from the previous period. The Average True Range or ATR, measures this true range over several periods, usually ten to 14 periods.
In 1978, Wells Wilder wrote "New Concepts in Technical Trading" in which he detailed several technical tools he had created. One of which was the ATR. He also detailed a way of setting a trailing stop to make sure that your stop is outside of the volatility range of the security. This volatility stop requires you to first calculate the Pivot Point of your stock. Don't worry, you add together the previous high, previous low, and previous close and then divide the sum by three. The formula looks like this: PP = (H + L + C) / 3, where H is the previous high, L is the previous low, and C is the previous close.
Once you have that figure, you simply subtract or add the ATR to arrive at where your stop should be. If you are long, subtract the ATR from the Pivot Point to see where to place your stop. When in a short position, you add the ATR to the Pivot Point for your stop placement. When you have a new period, you simply re-do the calculation for the new period and adjust your stop in the direction of the trade. Never loosen your stops!
The beauty of this stop system is its simplicity. Typically, volatility is great at the beginning or during a move, but will start to shrink as the momentum tires. This will cause smaller candles to form on your charts. It will also cause the ATR to shrink and will tighten your stops. So, in using this system, you will automatically tighten your stops when it makes the most sense, as price is readying for a possible reversal!
This volatility stop system was originally created for use on daily or longer term charts, but can easily be used for intraday trading as well. It is not perfect; there are times where a trend line, or other support or resistance level, may have worked better, but it is effective overall. The main thing you must remember is that whenever you are trading, you must prepare for an adverse move and protect your capital. If you do, you should only suffer small losses that can easily be overcome with small and large wins. Until next time, trade safe and trade well!
Have a great day.
- Brandon Wendell
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