Volatility Stops

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http://thepatternsite.com/stops.html#WIU

Volatility Stops

What happens if the current price is at 15 and the prior minor low is at 10? If price were to drop back, you’d give away 30% of your profits before the stop loss order sold your position. This situation often occurs during straight-line runs or in low priced stocks in which a small price move represents a significant percentage change. That’s where a volatility stop comes in handy.

I read about this in Perry Kaufman’s book, A Short Course in Technical Trading. The idea is similar to my beta adjusted trailing stop (BATS) that I introduced in an article for Technical Analysis of Stocks & Commodities magazine in January 1997. Stop placement was done using beta (a measure of volatility) and the current price.

In Kaufman’s technique, compute the average daily high-low price range for the prior month, multiply by 2, and then subtract the result from the current low price.

The following table shows an example based on Exxon Mobile’s stock (XOM) during July 2005.

Date        High        Low        Difference
1-Jul-05        58.44        57.60        0.84
5-Jul-05        60.23        58.46        1.77
6-Jul-05        60.73        59.03        1.70
7-Jul-05        59.54        58.29        1.25
8-Jul-05        60.12        58.97        1.15
11-Jul-05        60.00        58.72        1.28
12-Jul-05        60.24        59.40        0.84
13-Jul-05        60.05        59.37        0.68
14-Jul-05        60.15        58.31        1.84
15-Jul-05        58.94        57.88        1.06
18-Jul-05        58.47        57.69        0.78
19-Jul-05        58.82        57.93        0.89
20-Jul-05        59.02        57.99        1.03
21-Jul-05        59.05        57.85        1.20
22-Jul-05        59.70        58.15        1.55
25-Jul-05        60.47        59.45        1.02
26-Jul-05        59.97        59.50        0.47
27-Jul-05        59.90        58.85        1.05
28-Jul-05        60.11        58.97        1.14
29-Jul-05        60.17        58.75        1.42
Average:                        1.15

The difference column is the intraday high minus the low. The average of the differences for the month is $ 1.15. Multiply this by 2 to get the volatility, or $2.30. Based on the volatility of the stock, you should place your stop no closer than 56.45. That’s $2.30 subtracted from the current low (58.75 on July 29). If price makes a new high, then recalculate the volatility based on the latest month, multiply it by 2 and subtract it from the current low. This method helps you from being stopped out by normal price volatility.

Recent testing has shown that a multiplier of 2 is best (it used to be 1.5). Also, the look back should be 22 price bars. That is about a month’s worth of price data that you average.

The average high-low volatility measure (HL) performs better than the average true range (ATR, which includes gaps, whereas the HL method does not) and better than standard deviation. Standard deviation performed the worst of the three methods in nearly all of the tests.

For the test, I used about 100 actual trades I made from 1/1/2003 to end of 2005 and compared the performance of the three methods using various parameters to my actual results. I found that when using the HL method (with 2x multiplier and 22 bar look back), the average give back before being stopped out after price peaked is 6.88%, which is less than the 10% maximum I consider acceptable. The HL system made the most money and improved on the profitability of the trades 48% of the time.

Unfortunately, all of the stop methods tended to take you out of the best performing trades prematurely, so you can't use the method as the ONLY way to exit a trade. Discretionary timing the exit improved performance substantially. That means correctly choosing when to use a volatility stop and when not to is vital.