"I don't make jokes. I just watch the government and report the facts." Will Rogers

It is certainly no secret that the recent past has demonstrated a period of historically high volatility in the markets. One of my very successful coaching students from this past year wrote last weekend and suggested that I write an article dealing with setting stops in this high volatility environment. I agree that subject is something that might be helpful so what follows are some of my thoughts on the subject.

First I should say that a consistent mantra for me has been to have an exit strategy in place before ever entering a position. In that fashion, the exit decision is made out of the heat of battle when the trader can calmly decide on a disciplined approach to his exit. At the time of entry I believe the initial exit should be close to the entry and it should be clear. I personally define the clarity as some line on a chart. It could be defined by a trend line, a price support, a moving average, a MACD crossover, or any number of things that remove my emotion from the exit decision. If an exit is set in that fashion and adhered to, losses are essentially cut automatically. If I am wrong on direction I am out of the position with relatively little pain in most instances. That takes care of the clear part of the initial exit strategy. If I am right on direction, I may then follow the move by trailing stops or continuing to use the trend line as the exit (or one of a vast variety of other methods) in order to attempt to let my profits run.

The second part of my exit theory is that the initial exit should be close to the entry and that can be one of the most difficult things in trading. What is close for me may not be for you. You may be willing to risk a couple of dollars a share on a position and consider that amount to be "close" to your entry while I may define "close" as only 50 cents from my entry. This part of setting stops is one of the most subjective and difficult parts of successful trading in my book. One of the problems is that we don't want to be whipsawed out of a position. As an example, if we set our stop too close on a bullish play (like buying a stock), the price could dip, we would be stopped out of the position, and the stock could then turn back up and head north just as we supposed it might when we entered the play.

Setting stops, in my estimation, is probably more art than science and it is one of the reasons I advocate practice trading. Paper trade stop setting to see what works for you. In these volatile days, stocks have tended to move in a wider range both on a daily and on a weekly basis -- that's simply evidence of the volatility. The first thing I conclude from that wider range is that I need to change my definition of what is "close" during volatile times if I want to avoid being whipsawed out. How can this be done? Once again, it is subjective. A starting point may be to check out the daily range within which a stock trades. Placing a stop within that range may well result in getting taken out of the position just through the normal daily movement of the price. Recognizing that probability, we might want to be sure our stop is outside that range in an effort to avoid an exit occasioned by movements within the expected daily range. We might also consider looking at a weekly range to decide whether we want our stop within or just outside that range. The point is that we know the range for a day or a week is going to be wider when things are more volatile than they would be when volatility is reduced. That awareness can help us reach our own conclusions as to precisely where we might place a stop. In a less volatile market, stops may be closer and in a more volatile market they will be farther away if we expect to avoid the whipsaw.

I know of no hard and fast rule to set stops depending upon changes in volatility; I only know that as volatility increases we need to change our own approach. We simply can't expect to set the same stops in a volatile market as we would in a calm market and get the same results. This area is one in which I often spend a great deal of time with coaching students and which I have dealt directly in past seminars. It is one of the hardest yet most important subjects in attempting to arrive at high levels of success in trading. It is worth working with someone knowledgeable and practicing on your own because it can truly inflate your returns.

Good Trading!
Bill Kraft

November 8, 2008

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