Talk about volatile times! Not since the financial turmoil of 2008-2009, do I recall such consistent large swings in the stock market. The Greek crisis and China’s stock situation has resulted in tremendous trepidation. Add in the fact of interest rates about to climb and it paints a very volatile picture going into the future.
The good news is, as traders and investors, volatility is our lifeblood.
Stocks need to move for directional traders to make money. The more they move, the more profits that can be made by savvy investors.
Even for long-term investors, all this volatility has resulted in everyone being focused on the best way to take profits.
Many investors are great at entering winning trades but when it comes time to take profits, they don’t know what to do. Often these investors hold too long and give up the majority or all of their unrealized profits. Other times, they fearfully take the profits quickly rather than waiting for the maximum move.
Readers of our premium services are very familiar with our insistence of the use of stop losses when trading.
Today’s environment makes the use of stops losses even more critical. Remember, profits are created when you exit the trade or investment, not when you enter. Stops are how profits are realized.
Average joe traders do not understand how important stop losses are. Correctly using stop loss orders is the mark of the professional trader.
First, let’s take a closer look at the two primary types of stop orders.
- The Fixed Stop
The fixed stop is a stop loss order based on a particular price. Fixed stops can also be timed based. Fixed stops are best used immediately when the trade is entered. The order is placed a certain distance (more on this later) away from the entry level to prevent further losses.
A much less common way to use fixed stops is by using a time-based stop. Time-based stops are only used when you are positioned sized correctly to allow for significant adverse swings in price. Time stops are useful for traders who want to give a position X amount of time to profit then move onto the next trade.
- The Trailing Stop
Trailing stops are used to lock in profits but allow the trend to create additional profits. It is my favorite way to take profits since there is the potential to remain in a profitable position yet have the knowledge that profits are protected. Fixed stops are often converted to trailing stops once a certain amount of profit is realized.
As the name suggests, trailing stops are set to follow price by a certain distance.
An example would be that you entered a position at $8.00 per share. Price quickly moves to $11.00 per share, and you think it could run much higher. You set a trailing stop order at $9.00 per share to assure profits no matter what happens to the stock. For every point that the share price moves higher, the trailing stop moves one point higher. Meaning that when the price hits $15.00 per share, the trailing stop has automatically moved to $14.00 per share locking in the profits. Now, at the same time, should price fall back by one point, the trailing stop will activate closing out the trade.
Fortunately, most online trading platforms have a trailing stop feature built into them. Every trading platform is designed a little differently on how to use the trailing stop function. Learning how to use this feature can spell the difference between just another average year and a year of outstanding performance.
What’s The Best Distance to Set Stops?
Most traders only fly by the seat of their pants when it comes to setting stop intervals. Sometimes it is set based on a fixed number or how much money you are prepared to lose on the trade. There are a host of ways investors set stop order distances.
The good news is that there is one tool that guarantees the optimal setting of stops.
Technical analysis of stocks goes beyond timing entries. It functions beautifully as a tool to calculate stop distances in a consistent scientific manner. .
Traders are often confused when it comes to setting stops. Most just use a random distance away from the entry for the initial stop loss. Still others simply set a stop loss at the maximum amount they are willing to lose in the trade. This is generally some percentage of their account value.
The number one tactic for knowing the distance from the entry to set the stop utilizes a technical tool known as Average True Range or ATR.
Average True Range was first made popular by technical analyst Welles Wilder in his 1978 book, “New Concepts In Technical Trading Systems”
ATR processes a stocks volatility but not the direction, strength or length of a move.
In this context, volatility refers to how much does the stock move in a given period. This is also known as its price range. ATR is the average of the True Range.
True Range is the maximum of the current low and previous close, the difference between the present high and the last end, or the difference between the current low and the previous close
The true range can reference the greatest of the current low and previous close or the difference between the present high and the last close, or the difference between the current low and the previous close.
The average of the true range is then calculated over a set number of periods to determine the ATR.
The number of periods used is 14. These periods can be weeks, days, hours, or even minutes.
They should correspond to the time frame that you are trading.
If you are day trading, then intraday periods should be used.
Swing traders generally use days as the time frame.
A high ATR number means volatility is high during the period; a low ATR means low volatility.
Fortunately, most trading platforms have the ATR feature already built into them. There is no need to know the formula but for those who want to know HOW things work, here is the formula.
Here’s How To Use The ATR To Find The Optimal Stop Distance
1. Determine the ATR of stock times it by 3
2. Subtract this number from the entry price to determine where to set the initial
The reason this works is it keeps you in the stock during insignificant adverse movements. Price needs to move 3X the ATR to be stopped out.
As a word of experience, Average True Range is just a tool. While it provides a robust and statistically relevant framework from which to make decisions, it is not fool proof. Sometimes setting closer or further stops than 3X ATR is the prudent move.
The current stock market volatility has many investors nervous about the future. Unfortunately, investors often take profits too early out of fear or too late due to greed.
The optimal way to make profits is via trailing stops set within the framework of Average True Range. Doing so helps eliminate being stopped out due to directionless noise but will take profits or prevent additional losses in the face of significant moves outside of the stocks average range for the period that you are trading.