Trading Strategies Using Technical Analysis
- Thread starter SwingKing
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Setting Stop Losses
This is one of my favorite concepts in Trading because of its usability and its necessity. Many traders don't even know how to keep appropriate stop loss for a stock and yet they keep trading randomly. Either their stop loss is too low, or it is too near. In either case, achieving results is not possible. The key to setting a stop loss is to link it with the concerned entities volatility. Every stock has its inherent character (range of movement, pace of movement) and hence stop losses for every stock has to be different. The inherent concept could remain the same, but incorporation of volatility within its core methodology would be ideally the right way to go about it.
Again there are many ways to do this. But, here I will focus on how it is done through ATR (Average True Range). Now, before getting into the depth, lets first recollect what ATR is. It is is the difference between the high and low price on any given day. It reveals information about how volatile a stock is. Large ranges indicate high volatility and small ranges indicate low volatility. Essentially this means, if a stock A of Rs 100 has ATR (14) of 10 Rs and another stock B has ATR(14) of 5 Rs, then there is high probability that stock A can fluctuate 100 + 10 or 100 - 10 and stock B can fluctuate 100 + 5 or 100 - 5. Hence, stop losses for both cannot be the same as their fluctuation range is different statistically. I hope this is clear up till now.
Moving forward, let's actually see how it is done. There are many ways to implement ATR in stops. However, here I will explain it in the most simplest form. Let us assume we are using a Technical System where we Buy when prices crosses 20 day MA and Sell when the price crosses below 20 DMA. Now the initial stop loss considered by most traders in these systems is the 20 DMA itself. For Eg. If Nifty is at 5000 and it has crossed its 20 DMA (4950) today and given a buy, then many traders will keep 20 DMA (4950) as the stop loss. Now, keeping this stop loss is wrong as it does not take into account the inherent volatility which is being reflected currently. To make the stop loss more meaningful, we can subtract the 20 DMA with the 10 day ATR to get a more appropriate stop loss. This way, we would give ourselves, reasonable margin of not getting whipsawed again and again. Below I have attached a figure to understand this better.
Please see, the original stop above based on the 20 DMA and the modified stop above based on 20 DMA minus the ATR. The extreme right column will indicate the difference (%) between the two. As you can notice, year like 2008 where volatility was extremely high, the difference between the two prices is over 5%. Whereas today the difference is only 1%. This is reflecting the fact that 2008 was a highly volatile year and stops should have been lower as on up days markets were rallying close to 6-8% every session. This was done to avoid whipsaws. Whereas in 2010, markets are very low on volatility and traders should keep tight stop losses in order to lock their profits. Since 2008, we have entered into a low volatility phase. Volatility has been reducing drastically since 2008 and now we will at sometime start moving up in terms of volatility. This can be very valuable information for traders. Since volatility is more cyclical than price, the high volatile phase is bound to come.
P.S. - The above illustration is based on a very basic system. I am not encouraging you to use this system, but have just given you an example of how to use this system and avoid whipsaws by incorporating volatility in your trading. There are 'n' number of ways this can be done for your system, and now since you have a good understanding of the underlying concept, start experimenting till you find something that suites you.
Tc
This is one of my favorite concepts in Trading because of its usability and its necessity. Many traders don't even know how to keep appropriate stop loss for a stock and yet they keep trading randomly. Either their stop loss is too low, or it is too near. In either case, achieving results is not possible. The key to setting a stop loss is to link it with the concerned entities volatility. Every stock has its inherent character (range of movement, pace of movement) and hence stop losses for every stock has to be different. The inherent concept could remain the same, but incorporation of volatility within its core methodology would be ideally the right way to go about it.
Again there are many ways to do this. But, here I will focus on how it is done through ATR (Average True Range). Now, before getting into the depth, lets first recollect what ATR is. It is is the difference between the high and low price on any given day. It reveals information about how volatile a stock is. Large ranges indicate high volatility and small ranges indicate low volatility. Essentially this means, if a stock A of Rs 100 has ATR (14) of 10 Rs and another stock B has ATR(14) of 5 Rs, then there is high probability that stock A can fluctuate 100 + 10 or 100 - 10 and stock B can fluctuate 100 + 5 or 100 - 5. Hence, stop losses for both cannot be the same as their fluctuation range is different statistically. I hope this is clear up till now.
Moving forward, let's actually see how it is done. There are many ways to implement ATR in stops. However, here I will explain it in the most simplest form. Let us assume we are using a Technical System where we Buy when prices crosses 20 day MA and Sell when the price crosses below 20 DMA. Now the initial stop loss considered by most traders in these systems is the 20 DMA itself. For Eg. If Nifty is at 5000 and it has crossed its 20 DMA (4950) today and given a buy, then many traders will keep 20 DMA (4950) as the stop loss. Now, keeping this stop loss is wrong as it does not take into account the inherent volatility which is being reflected currently. To make the stop loss more meaningful, we can subtract the 20 DMA with the 10 day ATR to get a more appropriate stop loss. This way, we would give ourselves, reasonable margin of not getting whipsawed again and again. Below I have attached a figure to understand this better.
Please see, the original stop above based on the 20 DMA and the modified stop above based on 20 DMA minus the ATR. The extreme right column will indicate the difference (%) between the two. As you can notice, year like 2008 where volatility was extremely high, the difference between the two prices is over 5%. Whereas today the difference is only 1%. This is reflecting the fact that 2008 was a highly volatile year and stops should have been lower as on up days markets were rallying close to 6-8% every session. This was done to avoid whipsaws. Whereas in 2010, markets are very low on volatility and traders should keep tight stop losses in order to lock their profits. Since 2008, we have entered into a low volatility phase. Volatility has been reducing drastically since 2008 and now we will at sometime start moving up in terms of volatility. This can be very valuable information for traders. Since volatility is more cyclical than price, the high volatile phase is bound to come.
P.S. - The above illustration is based on a very basic system. I am not encouraging you to use this system, but have just given you an example of how to use this system and avoid whipsaws by incorporating volatility in your trading. There are 'n' number of ways this can be done for your system, and now since you have a good understanding of the underlying concept, start experimenting till you find something that suites you.
Tc
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For further reading on ATRs, please read also this....
http://www.amibroker.com/newsletter/03-2000.html
Thanks,
Shajan.
For further reading on ATRs, please read also this....
http://www.amibroker.com/newsletter/03-2000.html
Thanks,
Shajan.
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