Using stop orders is one way to limit risk, and limiting risk is the way to stay in the game. Yet stops seem to get hit all too often.
One of the worst feelings in trading is being right but still losing money. That is one of the problems with stops, especially those that are set too tight when stocks are seeing large swings, as we noted in a special report on the flash crash of May 2010.
Some traders have the fortitude to get back into the trade once they get stopped out, but that can take its toll. And, in many cases, the move is a clear sign that you were wrong with your original thesis.
Jack Schwager makes this point in his new book, "Hedge Fund Market Wizards." "Too many traders set stops based on their pain threshold rather than points that disprove their trade premise," he writes.
Stops should not be set on just a loss basis, but rather at a point that makes sense--a price at which you are willing to say you are wrong about the trade idea. If that stop is too large in terms of losses, then reduce the size of the position.
Options can provide a good alternative. Buying calls or call spreads is a limited-risk way of getting directional exposure without the worries of getting stopped out. But those who want to stick with stocks can use volatility data for better use of their stops.
There are two main types of volatility metrics. The first is historical volatility, which tells us how much the stock has been moving in the recent past. The second is implied volatility from the options, which can be used to compile an average--or volatility surface--for the stock. This tells us how much volatility is anticipated by option traders going forward.
Many traders may not be interested in how much volatility one expects in the next year, which is what this data usually tells us, but there are ways to break this down.
A VIX of 24 suggests that the S&P 500 will be higher or lower by 24 percent with a 1 standard deviation (67 percent) probability. This can be taken down to daily information by dividing by the square root of 252, the accepted number of trading days in a year.
So if the volatility is 32 percent, the daily move is expected to be 2 percent with a 67 percent probability. It makes sense to view anything within that move as noise, so a short-term trader likely wouldn't want a stop within that band.
For example, we can look at the SPDR S&P 500 (SPY) exchange-traded fund just below $133, with an average implied volatility of 21 percent. That is pretty much in line with its short-term historical volatility but above the 30-day reading as shown on the chart here. So the expected daily move is 1.32 percent, or 21 divided by 15.87. So the noise, in this case, is essentially 1.75 points up or down.
Again, options often provide the best way to limit risk and allow positions to be held through choppy moves. But those who prefer stocks with stop-losses should at least incorporate volatility data to determine the best trading parameters.
(Chart courtesy of iVolatility.com. A version of this article appeared in optionMONSTER's What's the Trade? newsletter of June 13.)
