perhaps not even making up for the costs of trading. If the volatility is too high,
all stops and exits will be hit too soon, which will result in a higher than normal
amount of losing trades, and winning trades that aren’t as large as they could have
been, given the momentum created by the volatility.
The same two things can go wrong with the fixed-dollar stop just described.
The differences lie in the fact that the efficiency of the percentage stop will vary
rather quickly over time as the volatility fluctuates, and this error is not dependent
on the price or current trendiness of the market, as it is for the dollar-based stop.
Thus, in using a dollar-based stop, we’re making a systematic error that might
compound and worsen over time, which will not be the case for the percentage-
based stop. Instead, only the short-term efficiency of the short-term stop will vary,
while the long-term efficiency is more likely to remain constant.Volatility
Unfortunately, while volatility can be observed all the time, it can only be meas-
ured in hindsight. But if you’re prepared to work under the assumption that the
most recent volatility also is a good indication of the volatility in the immediate
future, then you can replace the percentage-based stops with a set of more dynam-
ic stops based on the current market volatility.
If you do, you have to remember that the volatility also must be measured so
that it becomes universally applicable on all markets. Basically, there are two com-
mon ways to do that. The first way is to calculate the moves from one close to the
next, measured in percentage terms, and then calculate the standard deviation of
the price swings. This method is most commonly used in the academic world and
by options traders, who use it as a part of an options-evaluations formula, such as
Black–Scholes, to calculate the fair value of an option. (Options traders use a log-
arithmic scale, but in essence, it’s the same thing.)
Using this formula, the larger the swings, the larger the standard deviation
and the further away the stops and the exits can be placed from the entry price to
avoid being stopped out too early. For example, by placing the stop one standard
deviation away from the entry price, only 16 percent of all price moves should
reach the stop. If the stop is placed two standard deviations away from the entry
price, only 2.5 percent of all price moves should reach the stop. Whatever you
decide, the distance between the entry price and the stop will remain constant in
standard deviation terms, but vary in percentage terms with the most recent mar-
ket action. (Note that this is not the same as to say that only 16 or 2.5 percent of
your trades will be stopped out. There still is a 50–50 chance for the trade to reach
the lower standard-deviation boundary, as compared to its corresponding upper
standard-deviation boundary.)
However, for the standard deviation calculation to be statistically reliable, it
needs at least 20 to 30 observations (close-to-close moves), which means the look-210 PART 3 Stops, Filters, and Exits