STOPS
There are two situations when to get out of the market. Exits on the next page covers when the trade goes well and you need to take profits as the trend ends. The other is when the trade goes the wrong way and you exit through a stop. Stops help you cut your losses short by keeping your losses to a minimum when the price goes against your position. Using the same stock examples from the previous page on position sizing we have a $10 stock and $500 stock that both have a 14 day ATR of $2. We could have a tight stop of only one ATR of $2. If we have a long position and the $10 stock goes down to $8, we exit with no exceptions. If the $500 stock goes down to $498, we exit with no exceptions. A short position would be the opposite to cover at $12 and $502 with no exceptions. If we want to have a stop that isn't so tight, we can double the stop to 2*ATR or $4. In that case if the $10 stock goes down to $6, we exit with no exceptions. If the $500 stock goes down to $496, we exit with no exceptions. If the price goes the wrong way to your position, exit with no exceptions. When the trend looks like it will resume, you should have entry criteria that will give you a reentry trigger.
HAND IN HAND WITH POSITION SIZING
In either case above, we would keep the risk limited to the same percentage no matter the range of the stop since stops help determine position sizing. As you normalize your position sizes across markets, your stops also need to be normalized across markets. Using a Volatility Stop such as ATR allows each market to be treated equally to account for the daily movement. In addition to ATR, other indicators that account for volatility can also be used such a Bollinger Bands or a dev stop which is a standard deviation of the ATR as detailed in Trading with the Odds.
AVOIDING THE NOISE
Each market has a normal range that it moves each day that can be measured through the ATR. Stop levels should be set to attempt to not get hit when the market is moving in its normal range or avoid the normal "noise" of the market. While they should give enough room to avoid whipsaws , they should also be tight enough to not let the market take too much from you when a trade goes against you.
ADDITIONAL RISKS
While you try to limit your worst case loss with stops, be aware of other possible market conditions that may cause the price to go past your stop or result in unexpected losses:
- Gaps
- Limit up or down days for futures markets
- Reduction of liquidity
- Runaway price such as a crash
- Multiple whipsaws in a row before the market begins to trend
- Whipsaws in multiple markets causing a drawdown
In addition to stops, you have to decide when you want to take profits out of a position that catches a trend. The next page is exits.