How to set a Stop Loss based on Price Volatility?
Stop Loss based on Price Volatility! In simpler terms, volatility can be considered as the amount that a given market can effectively over, a given period of time. Placing a stop loss needs delicate balance. A stop loss needs to very tight, giving the trade, at the same time, adequate room to chisel or whipsaw. Active traders endure because they believe in using the initial protection of stop loss and trailing stops in order to lock or to break-even in profits.
A number of traders invest hours in attaining perfection on what is considered to be an ideal entry point. However, very few traders invest the same amount of time while creating an ideal exit point. This further creates a scenario where the traders can predict the right direction of the market but are unable to be a part of any huge return or gains because the trailing stop of the traders was hit or affected before that market broke or rallied in the trader’s direction. Actually, these stops are hit prematurely as the traders usually place it as per the dollar amount or chart information.
Three Ingredients for a Volatility Stop Loss
Understanding the average or natural volatility, a trader generally sets his/her stops in order to give his/her trade a room to breathe & a fair chance to set things right. The following are the three ingredients for a volatility stop loss.
Commonly there are 2 volatility measures among traders; standard deviation, and average true range.
Standard deviation can be considered as the default measure of volatility in the industry of finance. It can also be understood as the statistical term, which can measure the dispersion or variability amount around one average. Imagine a series of price in which the data of single price is equal to the average. The price series will look constant and flat. The price series will be devoid completely of volatility. The majority of charting platforms are capable of calculating the standard deviation.
Bollinger bands are an example of a stop loss method, which uses standard deviation. The Bollinger bands can give a trader an idea of the volatility of the market. Bollinger bands can be very useful while doing range trading. A trader should just set the stop beyond Bollinger bands.
Average True Range
Average true range (ATR) is the true ranges’ moving average. The typical period of look-back is fourteen. The true range takes into account the gaps with points two and three above. In markets, which do not gap, Average True Range (ATR) is just the average range and this is because the range of the price bar will be the greatest in every case. Examples of stop loss methods, which use ATR, are Chandelier Stop, and Keltner Bands.
Safety multiple can be considered to be one of the key features of one volatility stop loss.
Volatility measure can also be considered as the price tendencies of the market’s objective calculation. Similarly, safety multiple can be considered as the subjective inclusion from traders.
A low-multiple usually means one tight stop loss, which places risk-control above the potential of profit. A high-multiple produces a stop loss, which can risk more but at the same time, can offer a bigger room to breathe to the market.
This means the multiple can reflect the expectations of the trader of the price action.
Two and three are commonly used safety multiples that are used in the volatility stop losses. These can also be used as the starting point by the trader to experiment.
The ideal approach will be to extract one default multiple that is based on back testing the markets. Then, a trader can refine them according to each trading setup’s circumstances.
For example, for a long-term trend following the trade, a higher-multiple can be a good idea. Similarly, a low-multiple is suitable for a break-out trade, which a trader is expecting to hit his/her target swiftly.
As soon as a trader gets a stop loss distance, he/she should project the same from an anchor or reference price. The anchors of common price are the low, high & close to that price bar. In some cases, a price-moving average is also used as the reference price or anchor.
If you are looking for the price anchors’ smoother series, then you can consider using one moving average.
Stop losses are commonly based on support & resistance and price patterns. Sometimes, it is also based on one reversal signal, from an indicator, volume, or price action. This actually makes it very useful especially for the algorithmic traders.