September 27, 1999
This is the Fourth Article in a Series of Articles About Exits
Exits - Adaptive Money Management Stops
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 Average True 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.
In our next article about exits we will discuss various types of trailing exits.
* * * * * * * * * *
We are now offering a Free Trial of our Signals Service to any member who would like to sample the service. Fill out the brief form and we will send you the signals generated by our Trading Systems by email every evening for a limited time.
To sign up for the free trial go here: http://www.traderclub.com/signals_freetrial.htm
If you want more information about the Signals Service go here: http://www.traderclub.com/signals.htm
* * * * * * * * * *
Speaking engagements: We have several appearances scheduled over the next few months.
Chuck will be speaking at the Futures West '99 Conference & Expo in Long Beach on Saturday, October 2nd, 1999.
Chuck will be assisting Dr. Van K. Tharp in his workshop "How to Develop a Winning Trading System That Fits You". October 15 -17 1999 (This is billed as the Advanced workshop.)
Chuck will be a featured speaker at this year's Technical Analysis Group (TAG) Conference at the MGM Grand Hotel in Las Vegas. Chuck's topic this year will be: "A New Look at Exit Strategies". Nov 19 - 22 1999
For information and details go here: http://www.traderclub.com/events.htm
* * * * * * * * * *
That's all for this time
Good Luck and Good Trading
Chuck Le Beau's System Traders Club