Percent Stops
The percent stop method is the more straightforward of the two correct methods
used in this book. Simply put, it places the stop the same relative distance away
from the entry point, no matter the price of the stock. For example, a 10 percent
stop should be placed $1 away from the entry price if the entry price is $10, but
$10 away from the entry price if the entry price is $100.
To calculate what a percentage-based stop means in dollar terms for a spe-
cific stock, simply multiply the price of the stock by the fractional value repre-
senting the percentage value. For example, because the fractional value for 5 per-
cent is equal to 0.05, a 5 percent stop on a $60 stock should be placed $3 away
from the price of the stock (60 * 0.05 3).
To calculate how many percentages a certain dollar-based stop represents on
a certain stock, divide the stop distance by the price of the stock, and multiply by
100 to transform the fractional value to a percentage value. For example, if you use
a $6 stop on an $80 stock, the stop is 7.5 percent away from the entry price (6 / 80
* 100 7.5).
The last example was deliberately chosen so that I can refer back to the
Microsoft example. If it just so happened that you used a $6 stop on Microsoft
back in 1993, then you need to use a 38 cent stop (5 * 0.075 0.375) if you would
like to back test the system you used then on the same data as you used then: What
once was actually priced at $80 now seems to be priced at $5, and to make your
system behave the same, you need to adjust the stop so that it reflects the split-
induced changes in the price.
The main advantage of the percentage-based stop is that it works equally as
well, on average and over time, over a large number of stocks and different mar-
kets, no matter each individual market’s price at the time. Another advantage is
that it doesn’t need any new optimizable variables for its calculations. True, the
actual percentage values are optimizable, and the most optimal values will change
over time and vary from one stock to the next, but with a large enough sample for
testing, you will find the values that work best on average, around which the ever-
changing most optimal values will fluctuate.
The main disadvantage of the percentage-based stop is that it’s rather static
in nature and very seldom will it be the perfect stop for any individual trade. It
implicitly assumes constant market volatility, equal to the volatility that works the
best with whatever stop settings are in question. But because the volatility never
remains the same, and the changes only can be observed in hindsight, the per-
centage stop will only be almost perfect almost all the time. When it isn’t, it’s usu-
ally because the volatility is too high or too low.
If the volatility is too low, none of the stops and exits will get hit and the trade
will linger in no-man’s land for as long as the maximum allowed trade length
allows it to. This might result in several small losses and profits, with the profitsCHAPTER 19 Placing Stops 209