Have You Ever Been Stopped Out Too Early?
If you answered yes your probably like many traders who may not be optimizing their stop orders or placing them without regard for volatility. Many of us probably started out thinking about the dollar amount of our trade as our risk. Say you buy 100 shares of Apple Computer, symbol:AAPL, at a price of $100. You would be investing a total of $10,000 dollars in the position but if one looks at that as their total risk, they are essentially saying that they will buy AAPL and sell only if it becomes worthless and goes to zero.
This brings up a couple of issues, but for now understand that successful traders have entry and exit strategies. Defined methods for getting in and out while knowing their trading risk in advance.
The most basic tool available to manage risk is a stop order which comes from the phrase “stop my loss”. Traders generally will enter a position and then pick a level that if the market should hit or go past, a market order would sell their position. The challenge here is that like many of us, we would buy the same number of shares, or invest the same dollar amount, and using the same number of points down from entry or a uniform % on every trade rather than adjusting our position size.
Take a look any day of the week and you’ll notice by glancing at a quote machine that some stocks simply move in a wider range than others. Look at the daily highs and lows for Google versus a utility company who may only move that much in a year.
With this in mind, certainly placing a $3 stop loss on Google would probably trigger an exit the same day while for other positions it might be to wide. Stocks need room to breath so to speak and placing the same stop on each position may take traders out of potentially profitable positions too early.
The same principle applies when deciding how much to buy or sell short and setting stops based upon a stocks volatility, hence providing enough breathing room to account for normal price swings, may enable traders to better decide on how many shares to put on knowing what dollar amount they will lose should they enter and then get stopped out.
Average True Range-ATR to pick stop levels
ATR is a non-directional indicator in that it does not attempt to identify bullish or bearish posture. Instead, Average True Range looks at the previous periods price bar compared to the current price bar. In english, look on a daily chart. If Price today closed higher than yesterday’s close, it would take the distance between yesterdays closing level to the high of today. If price was lower today, it would do the opposite and you can see that this does figure in any price gaps.
The default number of periods the study evaluates is 14 so it is looking at the Average True Range over that time frame.
For those using ATR to adjust their stops, they look at the current ATR reading showing on the indicator and normally take that and multiply it by a number. Personally I like to take 2.5 X ATR which gives me my distance between my entry and exit. I then subtract it from my entry price and thats my initial stop in most cases.
Bought XYZ @ $40
2.5 × 2 = 5
Entry Price $40 – 5= $35
So $35 might be my initial stop loss level.
If one were buying 100 shares they would be risking $5 per share or $500 total.
This is potentially a way for traders to select positions sizing once they know the distance between entry and exit. Only want to risk $250? Then reduce the position size to 50 shares.
What if I use indicators or oscillators for entry and exits?
Many traders use indicators but say you are entering a long position every time a stock crosses the center line on MACD. One really doesn’t know what price will be when and if it turns back down below that centerline. Without knowing those levels, it becomes difficult to know your position risk at the onset of the trade so at least you have a line in the sand or basis for computing risk.
Now 2.5 times is only an example and each trader will need to figure out what works for them. But hopefully this helps in the quest to optimize a stop order.