As featured in the Herald Sun – Friday 2nd September 2016.
By David McCulloch – Market educator and consultant to Share Wealth Systems
Combining Price action and volatility to determine your stop losses.
When an initial stop loss is triggered valuable trading capital is lost. To protect the trading capital the initial stop loss should be set at a price where the stock is unlikely to move to based on recent history. Taking a look at any rising stock chart and you’ll notice how the price will tend to rise in a series of peaks and troughs. Each trough forms as a result of an area of demand in the market. It makes sense that the initial stop loss price should be set below that level. The main concept here is that the demand around that trough should prevent the price from moving low enough to trigger the stop loss, and therefore allow the trade to remain active.
If the price breaches the last medium term trough, the probability that the demand-supply equilibrium has shifted against the trade is increasing. The placement of protective stops below those levels is a matter of personal preference. We need to think about the impact of placing stops too close to the action, or alternatively too far away. In this example we are using price action to assist with the setting of the stop loss. A simple rule that you could apply to the setting of stop losses might be setting them at least 1% below the last medium term trough. It’s your choice, but whatever you decide, you must stick to it.
Placing a protective stop too close is a common mistake for newer investors, mistakenly thinking that by doing so they’ll not lose as much money if things turn against them. By doing so, they are ignoring what the market is telling them in terms of supply and demand, and how that appears on a chart as peaks and troughs. Placing a stop loss too close is just asking for the market to come and stop you out.
Volatility is the degree of price movement both up and down a security experiences over a period of time. Certain securities will experience more volatility than others. Paying due respect to the stocks volatility assists to minimize the risk of the stop loss being triggered by short term variations in the price of the stock being assessed. Volatility can also be measured in terms of ATR (Average True Range). If a stock has an ATR of $1.35, it means that on average it can be expected to move $1.35 in any direction during the next period. That figure is an average and so it goes to reason that there will be times when the stock moves more than that amount and times when it moves less. Placing a protective stop loss less than one ATR away is again just asking for the market to stop you out, it’s simply too close. Using at least two times the Average True Range (2ATR’s) as a bare minimum for the initial placement of your stop loss and combining that with a sound understanding of price action, is a sound model for your further consideration.
David McCulloch is a market educator and consultant to Share Wealth Systems.
