Trading Basics: Evolution of a Trader

VOLATILITY STOP

Mark is a novice trader who wants to make money, lots of money, but he does not want to lose a penny. He places a stop on every trade, but placed just 1 or 2 percent below his buy price. Within a day or two, he gets stopped out, taking small losses. Rarely, though, the stock climbs immediately and makes him a few bucks before the too-close trailing stop takes him out.

“Can you help me, Tom?” he asked. “What am I doing wrong?”

I told him that his tight stops were making him broker and his broker richer. I tried all sorts of explanations to convince him to use a wider stop, but nothing I said worked. He is an example of where the mental aspects of trading crippled his performance.

What he should have used is a volatility stop. I learned about it from Perry Kaufman (Wiley, 2003). A volatility stop is a trailing stop that is based on how volatile a stock is. Often, volatility is based on the true range, standard deviation, or high-low range of the stock. My tests revealed that the high-low range worked best followed by true range and standard deviation, respectively. Use whichever method is most convenient for you.

To compute a volatility stop, find the difference between the high and low prices each day for 22 days and take the average, multiply it by 2, and subtract it from the current low. The result is the stop price. Testing on actual trades found that 22 days and a 2 multiplier worked best, but different test methods and your trades may give different results. ...