Selecting the appropriate initial stop is fundamental to a successful trading plan. The importance of picking the initial stop should not be underestimated. There are basically four methods I suggest clientele to calculate an initial stop. You need to opt for the one that seems 'right' for you. The secret is not in which method you choose but rather that you just choose one.
1. Percentage method
What is it?
A predefined percentage of the price that you subtract from your entry price.
It's easy to calculate and is a better solution than not applying an initial stop at all.
The calculation doesn't consult price action and/or the volatility of an individual instrument. Different trading instruments have different risk profiles and don't move at the same rate. Using a fixed percentage method can limit you, causing you to get stopped out too early or too late.
2. Average true range (ATR) method
What is it?
The ATR is the (moving) average of the true range for a given period. The true range is the greatest difference between:
- the current high and the current low
- the current high and the previous close
- the current low and the previous close.
Very simply, ATR determines a security's volatility over a given period. That is, the tendency of a security to move in either direction. It's a great indicator used in many money management calculations. Most charting packages supply it.
This method simply subtracts a predefined multiple of the ATR from your entry price.
It consults volatility, giving more volatile trades greater room to move and less volitale ones a tighter stop.
The calculation doesn't consult price action; this can mean we might calculate the initial stop but it might not be at a support level. This method works best for longer term systems with wide inital stops such as 3-4 ATR multiples.
3. Technical method
What is it?
Some traders enjoy reading charts and/or looking at indicators. For many traders it's a matter of looking at price action and setting a stop based on the price action. I recommend setting the initial stop a few points below support to give it room to bounce should it need to.
If you're good with chart analysis, technical stops can work very well. I find technical stops are best suited to short-term trading.
The calculation can be subjective because it requires a certain level of intuition. This means there's a real danger of letting your emotions get in the way. Technical stops must be applied in a disciplined way. If possible I recommend still having some rules in place for setting these stops.
4. Lowest low method
What is it?
Look for the lowest low over a predefined period where the period is determinded by the timeframe you're trading. Similar to the technical stops I like to set my stop a couple of points below the identified low.
If your price entry was $24 and your look-back period was 21 days during which the lowest low was $21.55, you might set your initial stop level at $21.53.
It consults both price and volatility.
The calculation can cause an anomaly if the stock shifts sideways for an extended period and volatility dries up. The stop can leave little room for a stock to move.
So what is the secret to picking the right trading stop method?
Although I prefer the lowest low method, there really is no right or wrong stop method. By simply having a stop in place you're on the right track. Once you have a stop you must then determine how wide to set it. That's the trick and unfortunately there's no definitive answer... other than to test and see what works best.
Another additional kind of initial stop you could add in to what you have chosen is the time stop. If your stock is moving sideways for an extended period of time and your money is sitting there dormant you might want to get out. For example, your rule might be if it hasn't moved 2 percent within a certain time frame you'll exit the position. After all that's what stops are all about - putting a line in the sand that says, 'This stock hasn't done what I thought it would do so I'll get out.'
Choose the initial stop that works for you and stick to it in a disciplined manner!