Risk Management – Stopping Disaster

A reader asked about stops and to be honest I seldom use them – at least not hard stops – someone did point out once that I probably had mental stops and yes I probably do but I’m not afraid to take a loss. I could tell horror stories all day long regarding stops both from specialists who swept them to make a large trade for his own account to stocks that fell through them on bad news. So I seldom use them.

But the reader asked and I have to say that when I set stops now I normally set them based on the average true range of the stock. To get the average true range –

True Range = (The highest of the following three formulas)

Today’s High – Today’s Low
Previous Days Close - Today’s Low
Today’s High - Previous Days Close

The highest result is carried forward as the True Range into the next formula.

Average True Range = ((19 * ATRp) + True Range)/20

Where ATRp is yesterdays Average True Range

Because this is an exponential average the very first ATR has to be derived from a 20-period simple moving average. Fortunately most trading software will calculate the Average True Range for you.

I came to this after trying various percentages as well as fixed values based on the cost of the stock – e.g. 20 cents + a dime for each decile over 10. So a 30-dollar stock would have a stop of 40 cents. That’s probably as good as any other method but I like the ATR method in that it reflects the volatility of the stock and that to me at least seems scientific and is probably a good place to start.

Some people say you should double it but since I mostly buy and sell stocks I know I don’t bother with that. If I know them I know how they move.

Another good use of the ATR is for targets. For example I’m now holding three stocks in a swing trade mode – SYMC, ORCL, and ALTR. My target for each of these stocks is twice the ATR for a profitable sale or if any of them decline a single ATR I will sell it at a loss. For SYMC by way of example - I bought it at 19.89. If it touches 19.39 I will sell it for a 60-cent loss and if it hits 20.59 I’ll sell it for a double ATR profit.