Today’s Trading Lesson From TradingMarkets

Brice

Position
Management, Part I: Initial Stop Placement

By Dave
Landry

Most traders love to search for and discover chart patterns. Finding the next
cup-and-handle, breakout or a pullback variation that’s going to take off is a
fun and potentially rewarding challenge.

But finding such entry points is only one piece of the puzzle. Position
management is as important, if not more so, then entry techniques. In the first
of two articles, we will look at methods for placing initial protective stops
(IPS). In the second article, we will delve deeper into position management and
look at methods for trailing stops and taking profits.

There are various ways to determine where to place your IPS. You could use a
technical pattern, risk a fixed dollar amount or set the initial stop based on
the volatility of the market. Below we will look at the pros and cons of these
methods.

Volatility based stop methods measure the current volatility of the market
and place the IPS outside of the price range determined by that
volatility. Confused? Don’t be. The theory is simply that you will avoid getting
stopped out by the normal “noise” of the market, which is reflected by the
volatility measurement.

For example, if a particular market typically fluctuated three points per
day, you would be foolish to place a protective stop (for a position trade) only
one point away, because the chances are high the normal fluctuations of the
market would quickly trigger your stop.

There are various ways of predicting where the stops should be placed based
on the volatility. Below we will look at using historical volatility (HV)
and average true range (ATR). (Note: The formulas for average true
range and historical volatility are discussed in detail in the three-part series
on volatility in the

Education Section.)

Average true range (ATR) stops The

average true range of a market is just that: an average of the price range
(including overnight gaps) of a market. Once you find the ATR of a market, you
then take some multiple of it and add to the closing price to determine where
you stop should be placed. Shorter-term traders can use a small period (say,
several days) for the average and a low multiple (say 1 to 1.5) of the ATR.
Longer-term trend followers may use several weeks for the ATR and a multiple of
2 or more.

Figure 1 shows a two-period ATR and uses a multiple of 1.5 times the ATR.
Notice that as the average true range increases, the suggested stop placement
bands can get quite large (a). Also notice that these bands self-adjust to the
market: They begin to narrow as the volatility (in this case, the average true
range) begins to drop off. As you can see, even with a low multiple and short
period average true range, the bands can get quite large during volatile
markets.

Figure 1. Possible initial stop placement bands are created by using a multiple of the average true range. In this case, we took a two-period ATR and multiplied it by 1.5. We then added it to the closing price (for potential IPS for shorts) and subtracted it from the close (for potential IPS for longs). Notice that they expand (a) as the volatility of the market increases and contract (b) as the volatility of the market decreases. Source: Omega Research. Â

Historical volatility (HV) based stops With HV based stops,
historical volatility is used to predict where the market has the potential to
trade over the holding period (the forecasted length of the trade). That is, the
longer term HV (where the market has traded over a longer period), is reduced
down to the holding period. The longer the desired holding period, the more
likely the market will trade at its normal volatility. Therefore, where the
market is likely to trade over the next five trading days based on
volatility will be much less than where the market will likely trade over
the next six months.

In Figure 2, we have reduced the HV of the market down to a potential holding
period of three days. To show the volatility of the market increasing and
decreasing, we have plotted a short-term (six-day) HV reading. Like Figure 1,
notice that as the volatility increases the bands also increase (a) and vice
versa (b).

Figure 2. HV-based stops adjust the volatility of the market to the period you intend to hold the position. When markets become more volatile, the bands expand (a) and conversely, as volatility drops off, the bands contract (b). Source: Omega Research. Â

The advantage of volatility based stops is that they take into account the
noise of a market and determine stop placement outside of that noise, thereby
reducing the chances of being stopped out. The disadvantage is that such stops
can often be quite wide (far from your entry point), especially in volatile
markets.

In addition, there is no guarantee the market will maintain its current
volatility. Therefore, there is always the chance that even loose stops will be
hit. Whether you use volatility-based stops or not, you cannot ignore the fact
that the market has the potential to trade within these ranges.

With dollar-based stops, you determine how much you want to risk in a market
and place your stop accordingly. The advantage is that you only risk what you
are comfortable with; the disadvantage is that the market doesn’t care what risk
you are comfortable with–it will trade wherever the volatility of that market
dictates.

For example, at present volatility (mid-October, 1999) the S&P futures can
easily swing 10, or even 20 or more points on any given day. This equates to a
$2,500 to $5,000 move (or more) per contract (1 point = $250). Overnight moves
can be even more exaggerated. Therefore, if you are position trading and trying
to risk only a few hundred dollars per contract, you will more than likely be
stopped out–(and with slippage, lose even more than you intended with potential
overnight gaps).

This can be exemplified in a mechanical system (computer-based, 100 percent
objective): Adding dollar-based stops that are too tight will decrease
performance, and drawdown (losses) will actually increase as trades that
eventually become winners are removed due to being stopped out.

Day traders who take numerous trades and whose profits are limited to how
much a market can move in one day are forced to keep losses to a bare minimum on
(numerous) individual trades. Therefore, they may have to risk a fixed amount
(dollar stop) when trading. On the other hand, longer-term traders who take
fewer trades with the hopes of much larger profits per trade would probably be
better off determining the volatility of the market and placing stops
accordingly to avoid being stopped out by the noise of the market.

With pattern-based stops, you use technical analysis of the market to help
determine a logical place for the IPS. Below recent support, resistance, handles
of cup-and-handles, or the bottoms of pullbacks are logical places for an IPS.

For instance, if you are trading breakouts, the theory is that the market
should keep going after making a new high or low. It should not reverse; if it
does, its no longer a breakout. Referring to Figure 3, for the recent breakout
in Apple Computer (AAPL),
notice that after a consolidation the stock breaks out. Logically, the stock
should keep going; therefore, placing a stop right below the breakout day (a) is
a good place for the IPS.

Figure 3. Pattern-based stops. After a consolidation, AAPL breaks out. Placing a stop right below the breakout day (a) is a good place for the IPS. Source: Omega Research. Â

Pattern-based stops have the advantage of additional technical forces: buyers
may come in at support levels, sellers at resistance levels, and so on. The
disadvantage is that because they (to some extent) adjust to the volatility of
the market (i.e., the bottom of a wide range breakout), they too, can become
quite large.

Volatility-based stops have the advantage of reducing the chances of getting
stopped out with the added cost of risk. Dollar-based stops have the
disadvantage of frequently stopping you out of a position but at a lower risk
per trade. Pattern-based stocks incorporate technical analysis to help determine
where IPS should logically be placed. Because to some extent pattern-based stops
incorporate market volatility, they can often be large, like standard
volatility-based stops.

So which should you use? It depends on your trading style. If you are a day
trader, you may often be forced into using dollar-based stops to keep losses to
a minimum. The idea here is to withstand numerous small losses as you take
“stabs” at a market while waiting for the occasional large winner. Longer-term
traders whose profits come from catching one to several moves a year may
consider volatility-based stops to help reduce the risk of being stopped out by
noise alone on the next potential big winner.

One last point, in trading there are no “exacts;” therefore, you can use a
combination of methods. For instance, if you aren’t comfortable with the amount
of risk associated with technical/pattern based methods, you can reduce your
position size to decrease the amount of dollars at risk. Also, if you are a day
trader who’s forced to limit risk, you might still be able to apply the
volatility or pattern-based methods, but on a smaller intra-day scale.

When you’re choosing a method for setting IPS, you have to take your trading
style into consideration. Shorter-term traders are often forced into using
tighter stops and will likely get stopped out more often, whereas longer-term
traders will likely want to use methods that will help them avoid being stopped
out by noise alone.

Looking ahead: In Part Two of this series, we will look at
what to do after you’ve entered a trade and placed an initial protective
stop–that is, methods for trailing stops and taking profits.

Because initial protective stop placement is a vital part of money
management, I suggest you read the money management series in the

Education Section. Also, because much of the focus of placing the initial
protective stops involves studying the volatility of the market, I suggest you
read the volatility series in the Education Sectionas well.