TradingMarkets.com
The Myth Of Tight Stops
Tuesday November 18, 2:25 pm ET
By Dave Landry

Introduction
As a way to control risk, tight stops seem to be preached universally. This is either directly, by suggesting that you only risk a small fixed-point amount per trade, or indirectly, through phrases like "control you losses," "cut your losers quickly," and so on and so forth. The truth is, in many cases, tight stops may actually increase losses. From a swing trader's perspective (2-7 day holding period), we will look at why tight stops often do not work, how to adjust stops to accommodate a market's normal fluctuations and how to compensate for this added risk. Finally, we'll also look at cases where tight stops can and possibly should be used.

Background

Years ago, I remember testing my first mechanical systems. When I wrote my first profitable one, I began to think, OK, I'll put in stops and it'll really make some money. To my surprise, the system actually began to lose money. Why? Because the positions were stopped out long before they had time to work. The normal noise of the market alone was enough to hit these stops before the predicted move ensued.

Noise

I recently received an email from a swing trader who had seven losses in a row. What frustrated him was that soon after he was stopped out, these positions went in the direction of his intended trade. Under an ideal situation, you enter your position, place a tight stop and wait for the market to move in the direction of your trade. The reality, as this gentleman painfully discovered, is that the market often moves in the direction of your trade but only after some chopping around--also known as noise. This noise is often enough to take out tight stops and is illustrated in the figure below.

Calculating And Adjusting For Noise

Obviously no one knows exactly where a stock will trade in the future. However, judging by past performance, you can get a pretty good idea where the stock will likely fluctuate over a given period. This can be measured with statistically based methods such as historical volatility and average true range. It can also be measured by a simple "eyeballing" of the chart.

Average True Range

As the name implies, the average true range considers the true range of a stock by accounting for gaps. Looking to Juniper Networks (NasdaqNM:JNPR - News), a very volatile stock, we see that over a five-day period the stocks has an average true range of over 6 points (6.54). Longer-term (50-days) the stock has an average range of over 7 points (7.21). Therefore, if you intend on swing trading (holding two to seven days) a stock like Juniper which a travel range of at least 6-7 points per day, you're kidding yourself if you think you could use a tight stop (say 1-2 points) and not be stopped out.

Historical Volatility

Historical Volatility (HV) is the standard deviation of day-to-day price change expressed as an annual percentage.(1) Whew! Essentially, all that means is that historical volatility is a measurement of how much prices fluctuate over time. Suppose a stock or commodity is trading at $100 and its historical volatility is 10%. At the end of the year the market will likely (statistically a 66% chance, assuming a normal distribution and that volatility remains a constant, see appendix if you are interested in the math) be trading somewhere between $90 ($100 - 10%) and $110 ($100 + 10%).

If you take the longer-term historical volatility reading and reduce it down to the intended holding period, it gives you a good idea of where the stock has the potential to trade (2). I have plotted this calculation below on Juniper Networks based on the assumption that you intend on holding the position for five days. As of 04/30/01, this gives it a potential range of 46 1/2 to 71 1/2. This means in order to help ensure (but not guarantee!) that you won't be stopped out during this holding period, your stop would have to be at least 12 1/2 points away.

Eyeball It

As a chart reader, a lot of my analysis is done by simply looking at the chart. A simple "eyeballing" of a stock that trades from 40 to 50 one day, down to 39 the next day and then back up to 50 is a volatile stock. Therefore, I know that I'm kidding myself if I think that I can trade such a stock and use a 1-2 point stop.

Don't Forget To Adjust For Risk

When trading more volatile stocks, you obviously can't just loosen your stop out without compensating for risk somehow. You must look at total risk and adjust your position size accordingly. Risking 1% to 2% of your trading equity per trade is a good rule of thumb. Therefore, in general, you can trade more shares of a less volatile stock such as a consumer non-durable or a utility that normally fluctuates 2 points in a week and maybe only 10-20 points in a year than a wild-and-crazy technology stock that fluctuates 10-20 points in a day.

Avoid Anthills

Keep in mind that I am NOT suggesting you run out and use looser stops without a complete money management plan in place. Specifically, you must make sure that, on average, you are taking much more out of positions than you lose. For instance, you can't risk 5-points on each trade and only make, on average 1-point. Mark Boucher refers to such strategies as "Anthills." Ants can make a significant mound with little pieces but all it takes is one big footprint to knock it all down. Therefore, make sure your profits are large enough to justify the looser stop.

A Case For Tight Stops

Now that we have discussed the pitfalls of tight stops, there are instances where tight stops can and sometimes should be used. This depends upon the technical pattern and/or if you are willing to re-enter positions if your tight stop is taken out.

Pattern Based

In many cases, a stock should not break a technical pattern. If it does, it may suggest that the stock is failing. Therefore, in these cases, the stop can and likely should be placed below that pattern (for longs) even though this is often well within the normal noise of the market. An example of such patterns are low short-term volatility situations such as a high-tight bases. For instance, notice in the figure below that the hypothetical stock makes a narrow consolidation after a strong up move. The stock should not take out the bottom of this base. If it does, then it suggests that the stock may have topped out. Therefore, this provides a logical place to put your stop.

Keep in mind that in trading, everything isn't always "cut and dry." Sometimes, markets will make a false move below a consolidation before resuming their longer-term trend--a sort of "shaking of the tree" or "head fake", if you will. However, you must honor your stop because at the time it is occurring you have no way of knowing if it will turn out to be a false move (a) or a failure (b). This brings us to our next point--re-entering.

Re-entering

If you are willing to carefully monitor positions and have the discipline to re-enter if stopped out, then tighter stops can be used, even on volatile stocks. This is especially true in low short-term volatility situations such as the one described above. However, in general, keep in mind that many small losses can and often do add up to much more than one large loss, especially when you factor in the frictional cost (commissions and slippage) of all the additional trades. Also, keep in mind re-entry strategies are probably best suited for those with day trading experience who are used to taking numerous small losses and have the discipline to re-enter. If you can't watch a screen or psychologically aren't prepared to buy a stock that you just got stopped out of (sometimes over and over) then you're much better off using a somewhat looser stop and letting the position unfold as you think it should.

A Happy Medium?

The tighter the stop, the more likely you are to be stopped out. However, placing a stop where the statistics suggest is often too far away for most. Therefore, you can strike a happy medium and place your stop somewhere in-between. In this case, you know that your stop is within the normal noise of the market but it's less likely to get hit than a very tight stop.

In Closing

Tight stops, which many assume reduce the risk of trading, may actually increase risk as they are more likely to get hit due to the normal noise of the market. This reality must be factored into your trading plan. Above we have barely scratched the surface of the subjects of volatility, money management and technical patters. If you are to succeed as a trader, I strongly urge you to dig further.

Q&A

Q. How do you manage your protective stops? Statistically? Pattern based? A happy medium? Tight stops and re-enter?

A. I use all of the above. I mostly eyeball a stock to get an idea of where it has the potential to trade. I then look for a logical place that a stock should not violate. For longs, this can be the bottom of a pullback, the low of a setup, below recent lows, the bottom of a base, etc. In short-term volatility plays, I often use a tight stop and look to re-enter if it looks like a fake-out move.

Q. Is there a maximum percentage risk that you adhere to, regardless of what the statistics suggest?

A. As I wrote in my book, I normally don't like to risk more than 5% of a stock's value. However, there are cases were I might trade fewer shares and loosen that parameter.

Q. Such as?

A. If the overall market and sector conditions are choppy, if the stock is very volatile and/or if I know I won't be able to (or simple don't care to) watch a screen closely.

Q. OK, looser stops for an extremely volatile stock and for when you don't want to watch a screen makes sense. Can you explain market and sector conditions further?

A. Sure. If things are choppy then, I know that there is a high likelihood that stocks will fluctuate more before heading in the intended direction. On the other hand, if the market and sectors are really in gear, then I tend to use tighter stops.

Q. Define "in gear."

A. If the market and sectors have been trending, and/or I have market bias signals, then I might even use a tight stop.

Q. For instance?

A. Last week (late April), the overall stock market began coming out of a cup and handle. Biotech was on fire. In cases like these, I use a tight stop knowing that if I'm stopped out, I can either re-enter or probably find another stock in the sector that's moving.

Appendix

Calculating Historical Volatility

As with any indicator, I strongly urge you to purchase software with the indicators already programmed and would never suggest anyone attempt this by hand. With that said:

Let Length = length of volatility to be calculated and ln = natural logarithm

Historical Volatility(length) = standard deviation(ln(close/yesterday's close),length) * 100 * square root (256).

In English:

Divide today's close by yesterday's close.

Take the natural log of #1.

Take the standard deviation of #2 for length desired (the number of trading days, i.e., 50)

Multiply #3 by 100.

Multiply #4 by the square root of the number of trading days in one year (around 256).

HV is based on a one-standard deviation move

For those familiar with the bell curve and standard deviations, statistically, this suggests that approximately 66% the market should trade within these ranges. If you double the HV, which gives you two standard deviations, then this gives you a statistical probability that 95% of the time the market will trade within this range. A three standard deviation (3 * HV) would suggest that the market would trade within that range 99.7% of the time.

Keep in mind, however, that these calculations assume a normal distribution and are based on present volatility (volatility is constantly changing). Natenberg said it best in Option Volatility and Pricing Strategies: "(You) shouldn't confuse unlikely with impossible."

Using HV to set protective stops

In Connors on Advanced Trading Strategies, Larry Connors shows that historical volatility can be used to determine where stops should be placed. Calculation of these stop points are as follows:

Divide 260 trading days by the number of days you intend to hold the position.

Take the square root of #1.

Divide the historical volatility by #2.

Take the stock price and add (for shorts) and subtract (for longs) #3 from it.

Footnotes 1,2. Connors On Advanced Trading Strategies, Laurence A. Connors. See the appendix for the formula for HV.

Additional Reading

Option Volatility and Pricing, Sheldon Natenberg

Dave Landry On Swing Trading, Dave Landry

Connors On Advanced Trading Strategies, Laurence A. Connors

Dave Landry is a co-founder of TradingMarkets.com. A Commodity Trading Advisor (CTA), Mr. Landry is principal of Sentive Trading, a money management firm, and a principal of Harvest Capital Management, a hedge fund. He is the author of the well-respected trading book, "Dave Landry On Swing Trading," found at TradersGalleria.com.

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