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Everyone knows that stop loss orders should be used for each and every active market position. The reasons which are usually cited revolve around risk mitigation, being free from watching the market 24/7 and even the psychological impact of consistent trade planning. Regardless of the reasoning, it is agreed across the board that stops are essential.
There are several different ways of setting a stop loss order and the methodology will be dependent upon the individual’s risk tolerance and time frame. For a DividendKey investor, the stop loss is dependent upon fundamental factors and not on a falling price. For example, a company may drop 20% in price, but as long as it maintains dividend payments, it remains in the portfolio. If it rises 20% in price, but can no longer provide fully franked dividends, then a sales order is triggered. For a majority of shorter term traders, price, however, is the most important determinant of the stop and will dictate both the initial stop and any subsequent trailing or progressive stops.
The initial stop is vital for both quantifying risk and calculating position size, which should be a function of the risk capital (probably a percentage of the total account). This is relatively easy to calculate as:
| Risk Capital |
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= The number of shares/CFD/Futures etc |
Entry – Initial
Stop Loss |
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Most initial stops usually come in the guise of ‘technical stops”. These are placed based upon some degree of technical analysis derived from the predominant chart pattern. For example, in the image below the Elliott Wave trader has decided to place stops below the Wave Four. Technically this is a good position because it takes advantage of price support whilst also ensuring the trade is in the direction of the overall market trend. That is an upward trend is characterised by a series of higher highs and higher lows, a retreat in price below the Wave 4 low would represent the formation of a lower low – hence, a break in trend.
click to enlarge
A technical stop can also be used in a progressive manner, trailing and locking in profits behind an advancing price. Gann used one such method in his original mechanical trading system, moving stop loss orders progressively higher behind each swing bottom (for a long trade).
Traders also employ volatility models when trailing stops. This might sound extremely complicated, but actually is quite a simple strategy. The advantage of volatility based stop losses is that there is a form of feedback between market action and the proximity of the stop loss to the actual price action. If the trading instrument is extremely volatile, the stop loss will be further away from the price, and if the volatility decreases, stops will be tightened – hence keeping the trader in the position longer.
Average True Range was developed by Welles Wilder and as per the following simple formulae that calculate the true range and then the average of that true range over a number of periods. The True Range is the greatest of either of the following:
Current interval's High - current interval's Low
or
Difference between previous interval's Close and current interval's High
or
Difference between previous interval's Close and current interval's Low
When the True Range is determined for each interval, they are then averaged to find the mean:
| Average True Range (ATR) = |
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Sum of "X" True Range
(TR) values |
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"X"
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At the day of entry in our example, we can use the indicator function in ProfitSource to see the ATR is around 27 cents.
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Typically, traders will look for a multiple of the ATR and trail their stops accordingly, based upon optimisation in the back testing process. Currently for GUD in our example 2 times ATR is sufficent. Of course, it is still necessary to convert this figure into a price point. In order to do this, simply take the ATR mulitply by 2, and subtract this from the day’s low (but only on days that the market rises).
Entry at $5.37 on the 11th May, with the stop loss below the Wave Four ($4.86)
Market rises on the 12th (the low of that day is $5.50) stops moved to (ATR x 2= 54 cents), stop loss moved up to $4.96.
The stop loss is constantly moved up until the profit target is activated or the market returns and causes the stop to be taken out. In the following image, stops are trailed until the market corrects – causing the stop to be triggered on the 24th of April.
click to enlarge
Using the “Trailing Stop” indicator in ProfitSource allows you to do this automatically. The image above shows the stop losses represented by purple dots calculated daily by the software. As you explore ProfitSource you will see several other different ways of setting trailing stops. For more information on these, simply select the ‘help’ function and learn all about them.
Stay Sharp,
John Jeffery
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