Use a Volatility Based or Volatility Adjusted Stop Loss

Volatility based or volatility adjusted stop losses can reduce the frequency of premature and unnecessary sales. We think they are the best choice when there are no obvious regions of support to use as a reference. They are far better than using a straight percentage. They can allow just enough wiggle room so the stop wont be triggered by normal noise as the stock works its way to higher price levels.

The basic stop-loss is an order to sell the stock at the market if it drops a certain price. When you buy a stock, you are relatively sure it is about to rise. What if you are wrong? The use of a stop loss is endorsed by nmearly all successful traders and investors. It is one of the best tools a person can use to limit losses while letting profits run.

Experienced traders make it a rule to always enter a stop-loss order whenever they take a position. Thats because they have learned not to invest or trade without a safety net. It is the way they draw a line in the sand and say this much of a drop I can tolerate, but no more. Use of a stop loss enables a trader to be on a fishing trip or otherwise occupied, and if the stock falls more than it should, it is sold. When the stock declines to the stop price, the order changes to a sell-at-the-market order, and the stock is immediately sold at whatever the current market price is.

The order is usually good for a limited time or it is GTC (Good-Till-Canceled). Stop loss At-the-market orders are usually preferred over limit orders because a limit order can result in your not selling at all. That is, for a limit order to be executed, the stock would have to be at the limit price. When a stock is falling rapidly, it is generally better to get out than to quibble over price.

How does one determine where to put it? A stop-loss order can cause you to sell prematurely if you put it too close. On the other hand, if it is too far away, it will not offer much protection. Traders and investors will usually want their orders to be activated somewhat below a price where the stock is likely to get support. For example, if the stock bounces every time it drops to $47, that means there is support at $47. A trendline is also a region of support (because the stock tends to bounce off that line). If a stock is in a rising trend, and the trendline defining its rise is at $39, a trader might set the his stop loss order at $38. A stop loss could also be based on a drop of a certain percentage or on a drop that is beyond the normal fluctuation range or volatility of the stock (well come back to this approach later). The market does not know or care where you bought a stock. If a stock falls X% below your purchase price, it means absolutely nothing to the market. The market is much more interested in its own patterns of support and resistance.

For example, on 1-3-08 support for Valero (VLO) was at about $68.05. During the following 20 days, the stock dropped to $47.80. If a volatility based stop loss order were used, it could reasonably have been placed at about $67.75. Such a stop would have saved the investor from having a loss of more than 29%. The stop loss would have triggered an automatic sell order at the market when the stock fell to $67.75. The stock did hit that price, and then it continued to drop.

It must be acknowledged, though, that even if the stop loss were placed at $67.75, the stock may not have been sold at that price. Remember that the stop loss becomes a market order when the stock falls to the trigger price. The order would then be executed at the best price available for the next transaction. A frightening news item might be released that causes the stock to gap down from above to well below the price of your stop loss order. If that happens, your stock will be sold at the next available price below the gap.

This page is merely an introduction to the subject of stop losses. The following blue link will take you to more detailed information. At the bottom of the next page is a group of links to ten pages that discuss various aspects of stop losses and their placement.