In order to study and develop money management stops that are
adaptive to current market volatility, it is necessary to move
away from the standard dollar stops and examine other ways to
place the protective stop based on some measure of market
volatility.
One starting point is to use the price
action itself to determine the stop placement. For instance, the
lowest low or highest high of the last X number of days could be
used as a money management stop. We call this a Channel Stop. The
Channel Stop is very adaptive to current market conditions, since
it changes with trendiness and with volatility. The Channel Stop
is further away from the market in times of higher volatility and
higher trendiness and closer to the market in times of lower
volatility and lower trendiness. This stop is also based on strong
logic: we already know that a breakout of a significant highest
high or lowest low will often signal an important trend reversal.
Therefore our stop-loss placed at a highest high or lowest low
point provides a valid technical reason to exit a losing trade.
However one possible disadvantage of
this stop is that in a strongly trending market, the stop may be
placed too far away. Reflecting the strength of the trend the
market might have moved a significant distance from its previous
highs or lows. On the other hand, during non-trending periods, the
stop may be placed much closer to the markets. As you can see, the
actual dollar value of the stop would vary considerably depending
on where prices have moved from their last high or low point.
This variation might make dollar estimates of the risk per
trade difficult to predict until it is actually time to enter the
market.
Another adaptive strategy would be to
use significant support and resistance levels to define the money
management stop position. One could use a significant pattern in
the market, such as a pivot low or pivot high, as the position for
a money management stop. The advantage of using price and
technical points to determine the position of the money management
stop is that the stop is placed in a logical position, where
adverse price movement exceeding the stop would constitute a
logical reason for terminating the trade.
Another way of adjusting money management
stops is to use a measure of the current market volatility. We
could use the Average True Range over a period of time or the
Standard Deviation of prices over a period of time and multiply
that by a factor to determine how far away the stop should be
placed from our entry price. One of our favorite stops is to
simply take the Average True Range over a number of days and to
multiply that by a factor and place the stop at that distance from
the entry point of a trade. To avoid random price movement, it
would be recommended to place the stop more than one AverageTrue
Range from the entry price. The advantage of using a stop
determined by Average True Range is that it is highly adaptive to
current market conditions. The distance from our entry point to
the stop would increase in periods of high market volatility, and
decrease in periods of lower volatility. In actual practice we
have found that most problems with the ATR stop tend to arise when
the short term average true range becomes unusually small and our
tight stops cause us to be whipsawed.
To avoid these dreaded whipsaws we calculate both a short
term ATR (3 or 4 days) and a longer term ATR (15 or 20 days) and
we always set our stops using whichever of the two ATRs is the
largest. This allows
the stops to move away quickly but prevents them from moving in
too close after a few unusually quiet days.
(See Bulletin #14 for a discussion of ATR exits.
See Bulletin #10 for instructions on how to calculate ATR.)
Another version of an adaptive money
management stop would be to use the Standard Deviation of the past
prices as the measure of price volatility. For example, the
standard deviation of a past number of closing prices may be
calculated, multiplied by a factor, and the money management stop
could be placed at this distance away from the entry price. The
rationale of this stop is similar to the Average True Range stop.
The goal is to place the stop out of the reach of random price
movements yet cut our losses when prices move away from our entry
by a significant amount.
Adaptive stops that change with market
volatility have a significant role in money management. The dollar
amount of the potential loss can quickly be calculated before we
enter the trade and we can be confident that the size of the
potential loss is appropriate for the current market conditions.
As an example, suppose our system calls for the placement of a
stop at 1.5 times the 20-day Average True Range from our entry
point. If we were trading the S&P 500 market back in 1990
where one Average True Range was only $1,250 in dollar terms we
would have been placing our stops $1,875 away from the entry
point. Now suppose we had an account of $100,000, and we were
willing to risk 10% of our capital on each trade. Based on the
volatility in 1990 we would have been trading 5 contracts, thereby
risking $9,375 of our capital. Now suppose we are in 1999 trading
the same system, and one Average True Range in the market is
$5,600. This would call for a stop of $8,400. If we were still
trading the same $100,000 account with a 10% risk tolerance, we
could now trade only 1 contract. As you can see, the adaptive
money management stop is an excellent guide to managing risk
during periods of changing market volatility. |
