Adjusting Stops For Volatility

By Loren Fleckenstein

As an intermediate-term trader, I prefer to use a fixed initial price stop of 5%

when I buy into a new position. This simple mechanism allows me to keep the
majority of my positions at the same dollar value on entry.

However, there's no reason that an advancing stock has to obey my 5% rule. If I

believe a stock's normal volatility exceeds my 5% stop, I may relax my stop to
allow for more breathing room. But I will not relax my risk management. To the
extent I relax the stop, defined as a percentage of my cost, I will reduce my
position size accordingly.

Before going into this technique, let me ask this question: Are you successful
using a fixed initial protective stop? If so, think twice before departing from a
proven approach. If a stock just looks too volatile to tolerate your stop, consider
looking elsewhere for your trades.

We all have got stopped out of new buys only to see the stock head higher right
after throwing us into cash. It's impossible to avoid some stop-outs in trading. So
accept these small losses as part of the price of doing business.

One way to deal with this is to stick with your stop-loss rule, accept the loss, but
buy back in if the stock sets back up and heads north. For more on this
approach, check out Greg Kuhn's lesson, Handling Breakout Whipsaws.

That said, you can adapt your stops to take into account greater volatility around
your pivot or entry point. I have no magic formulas. Use the volatility measures
that work best for you. I look at the chart of each stock myself and make my own
eye-and-gut determination as to whether my normal 5% stop will suffice.

For those of you who would like to investigate volatility further, see Dave Landry's
three-part series Introduction to Volatility, Historical Volatility and Volatility In
Action.

Position Stops And Account Stops

Whenever I trade, I mentally have two stops: a position stop and an account
stop. The position stop is simply the maximum that I will allow the share price to
move against my trade, beyond which I will sell my buy or cover my short.

As I said above, I use a 5% stop in most cases. Under this stop, I will allow a new
buy to fall no more than 5% below my cost. Beyond that point, I sell. Before
buying a new stock, I may choose to use a wider stop, say 10%, if I think more
breathing room is necessary.
In either case, once a stop is decided, I stick with it. I don't, for instance, set a 5%
stop, then if the stock falls below that level, make excuses and change the
percentage to give the stock more time to prove me right. When the market
proves me wrong, I accept the market's verdict and liquidate.

My account stop is not subject to revision under any circumstances. The account
stop is simply the maximum allowable loss in any given position expressed as a
percentage of my total account value.

Let's say that I set my account stop at 1% and my account value is $100,000.
The maximum allowable loss in any individual position is $1,000 (.01 X
$100,000).

Imagine that I buy a stock that appears to have "normal" volatility under my
personal trading regime. I would use my 5% position stop. I would buy no more
than $20,000 in the stock. This maximum position size represents the
intersection of my position stop and my account stop. To find your position size,
simply divide your maximum allowable loss by your position stop. In this case,
the calc is $1,000/.05, which yields $20,000.

Now let's say that I decide to buy a different, more volatile stock. Because of the
greater volatility, I choose a wider position stop of 9%. While the position stop
has changed, my 1% account stop remains inflexible. So I must reduce my
maximum position size accordingly. I will buy no more than $11,111 of the stock
($1,000/.09).

Fixing Stops According to Support

One way that I like set stops is by looking at the chart, find a support level and
setting my stop slightly below that support level. Then I size my position to keep
the maximum loss within the bounds of my 1% account stop.

Choose the support levels that work best for your style of trading, then calculate
the percentage from your position share price to the identified support level to get
your percentage position stop. Then divide maximum allowable account loss by
percentage position stop to get your maximum position size.

To see how this works, imagine that you're contemplating a possible breakout in
Yahoo in 1997. (Apologies for the use of decimalized prices. This chart was
created post-splits.)
Let's make some other assumptions. You have $50,000 in your account. Your
maximum allowable loss as a percentage of your account is 1.5%. So the dollar
value of your maximum loss in any trade is $750. (.015 X $50,000).

You're watching Yahoo when, on June 18, 1997, the stock sets the price high of
a handle structure at 2.948 a share, which we'll use as our pivot point (see Point
A in the above chart). Assume that you decide that if Yahoo takes out that high,
you'll buy.

In order to plan ahead for your position stop and position size, you must make an
assumption about what price you'll get in. You assume that you'll get in at 3.04 a
share. This represents 3% beyond your pivot. Because you're a vigilant trader
with a brokerage that provides excellent order execution, you usually get in much
closer to the pivot. So an assumption of 3% price extension represents a
conservative estimate on your part.

Looking at Yahoo's chart, you notice the stock has found support in a relatively
tight trading range in the prior weeks. You extend a trend line along the lows
beneath the price handle (see green dotted line in chart). You decide this
notional line will define a probable support area. A cross below this line, in your
view, will represent a bearish shift in the stock's character, and you'll sell. (No
excuses, now. If the stock hits your sell your rule, you'll sell!)

Using this line, you decide to set your position stop at 2.6 a share, or 14.5%
below your presumed purchase price. Now you have enough information to
figure out a position size that (1) gives Yahoo enough breathing room according
to your view of where the stock should find support while (2) keeping your
exposure within your maximum risk tolerance of a $750 drawdown to your
account before you run to cash. Just divide your maximum loss ($750, in this
case), by your percentage position stop (.145). You get a maximum position of
$5,172.
Assuming you get in at a share price of 3.04 or less, a 14.5% decline in a $5,172
position would represent a $750 loss or less to your account. Now you know, in
advance of the breakout, how much stock you will buy.

Don't wait until a breakout occurs to calculate your position size from the
prevailing best ask price. You won't have time. While you're fumbling with the
math, the share price could move higher. In fact, it should move higher rapidly if
you've spotted a valid breakout. The key to exploiting breakouts is rapid order
execution. Form or refresh your estimates before the market opens, and prepare
to act quickly.

Yahoo shares broke out on June 20, closing at 3.271 on double normal volume
(see Point B). Let's assume you got in at 3.04 a share. Thereafter, the stock lost
ground, drifting lower, then spiking lower on June 30, marking an intraday low of
2.703, before recovering to close near the high of the day's trading range (Point
C).

In this example, your stop kept you in a winning position. Your maximum price
low of 2.6 was never touched. After the June 30 shakeout, Yahoo headed north.

Copyright © 2001 by TradingMarkets.com, Inc.