Last Thursday (May 6, 1999), we talked about how to calculate the likely closing range of a stock within a certain time frame using historical volatility. Today we’ll discuss how to apply these calculations to your trading.
Using the example from my previous article, we showed that Knight/Trimark (NITE), priced at $150, had a 67% chance of closing between 128 * and 171 * over the next five trading days. Therefore, let’s assume you believed, based on your other research, the stock would rise over the next week. After buying the stock, you need to put in a protective stop to minimize the risk of substantial disaster. In this scenario, if you buy the stock at 150, you want to make sure your stop is not too tight because the historical volatility reading is telling you the stock is likely to close as low as 128 * within a week.
A stop too close (i.e., at 148), may allow you to only risk two points but it is highly likely to get hit. Therefore, historical volatility is telling you to put your stop further away to allow for the market to fluctuate in its likely trading range. Obviously, if you are placing your stop at, say, 130, you also want to adjust your position size downward because you are risking 20 points on the trade.