Tuesday, June 7, 2011

Stop/Loss Rules

I've added a section on stop/loss rules to my "How I Trade" documentation on the menu bar.

The new part follows. I suggest reading the whole "How I Trade" document to put it in context.

Price Channel Stop/Loss Rules

Rule 1, first and foremost: Every position must have a stop/loss, preferably one that has been entered into the brokerage system. No exceptions.

However, choosing the proper stop/loss is not a matter of one size fits all. What follows is a description of how I set stop/loss levels on price-channel positions.

Elements used in setting a stop/loss level

I'm concerned that my stops not be so narrow that I'm constantly trading out of positions experiencing minor setbacks, nor so broad as to incur large losses if the trend has in fact reversed.

Those needs must be met by considering:
  • the volatility of the position, how much it moves on average each day,
  • the strength of the trend, how quickly is it progressing,
  • the change in the trend, whether it is growing stronger or weaker.

In my system, volatility is measured by the 14-day average true range (ATR), the trend strength by the 14-day average directional index (ADX), and the trend change by the direction of the average directional index (rising or falling).

The volatility is expressed in multiples of the ATR (1x, 2x), the strength by the ADX number, which generally ranges from the single digits into the 40s, and the change by the direction of the ADX, either rising or falling.

Initial stop/loss

Upon entry I set the stop as follows:

Bull positions: Set the stop at the breakout level minus 1x ATR or at the breakout day price low minus 1x ATR, whichever is highest.

Bear positions: Set the stop at the breakout level plus 1x ATR or at the breakout day price high plus 1x ATR, whichever is lowest.

The initial stop/loss remains in force as long as the position is under the two-day rule (see exit rules, above). Once the position is free of the two-day rule, the stop/loss is set using the ADX.

However, the initial stop/loss is closer to the extreme (higher for bull positions, lower for bear positions), then I'll retain the initial stop/loss.

Within this system, when there's a choice, the tightest stop wins.

ADX-based stop/loss

The goal is to set a stop/loss that preserves profits in strong trends, allows room for maneuver in middlin' trends, and shows little mercy to weak trends.

The stop/loss is set as a multiple of the ATR below (bull) or above (bear) the greatest price extreme attained since breakout.

The ATR multiple varies depending upon the both the strength of the trend (the ADX number) and the trend change (the direction of the ADX).

In setting the multiple, I divide the ADX into ranges: Low (below 25), Middle (25-39), High (40 and above).

Rising ADX
trend strengthatr
40 and up1x
below 251x

Falling ADX
trend strengthatr
40 and upclose
below 250.5x

Note that a position with an ADX of 40 and above is closed when the ADX turns down, the idea being that such a high ADX reading means the stocks will be seen as having gone too far too fast, and the pullback may well be extreme as people lock in high profits.

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