The first thing you need before you initiate any trade is to identify your stop-loss (SL) price. The SL is a price level beyond which you will not take any further losses. For instance, if you are to buy Nifty futures at 5200, you may identify 5100 as your stop-loss level; you will be risking 100 points on this particular trade. The moment Nifty falls below 5100, you exit the trade. The question is: How to identify the appropriate stop-loss level.
One approach used by many traders is to keep a standard pre-fixed percentage stop-loss. For example one could have a 2% stop-loss on every trade. So if you are to buy a stock at Rs.500, then your stop-loss price is Rs.490 and you risk Rs.10 on this trade. The problem with this approach lies in the rigidity of the practice. It does not account for the daily noise / volatility of the stock. As a result you could be right on the direction of the trade but could still hit a ‘stop-loss’. More often than not, you would regret keeping such tight stops.
An alternate and effective method to identify a stop-loss price is by estimating the stock’s volatility. Volatility accounts for the daily ‘expected’ fluctuation in the stock price. The advantage with this approach is that the daily noise of the stock is factored in. This literally means that we are eliminating the chance of placing an irrelevant stop-loss. Volatility stop is strategic as it allows us to place a stop at the price point which is outside the normal expected volatility of the stock. Therefore a volatility SL gives us the required logical exit in case the trade goes against us.
Let’s understand the implementation of the volatility based SL with an example.
This is the chart of DLF. For the sake of our understanding, let’s assume we are bullish on the stock and plan to buy it at 185 with a target of 210, expected to be achieved in the next 5 trading sessions.
Step 1: We estimate the daily historical volatility of the stock. Take a look at this post to understand how to calculate a stock’s volatility. Recall, volatility of the stock is a nothing but the standard deviation of the stock prices. For DLF as of today, the daily historical volatility is about 3.01%.
Step 2: Convert the daily volatility into the volatility of the time period we are interested in. To do this, we multiply the daily volatility by the square root of time. In our example, our expected holding period is 5 days, hence the 5 day volatility is equal to 3.01*Sqrt(5). This works out to be about 6.73%.
Step 3. Calculate the stop-loss price by subtracting 6.7% (5 day volatility) from the expected entry price. 185-(6.7% of 185) = 172.
Step 4 : Estimate the risk reward ratio to check if it falls within your expected guideline. In this example we are risking 13 Rupees for a gain of 25 Rupees (Risk to Reward ratio of 1:1.9) which seems like a reasonable bet.
Note : In case our expected holding period is 10 days, then the 10 day volatility would be 3.01*sqrt(10) so on and so forth.
Pre-fixed percentage stop-loss does not factor in the daily fluctuation of the stock prices. There is a very good chance that the trader places a premature stop-loss, well within the noise levels of the stock. This invariably leads to triggering the stop-loss first and then the target.
Volatility based stop-loss takes into account all the daily expected fluctuation in the stock prices. Hence if we use a stocks volatility to place our stop-loss, then we would be factoring in the noise component and customizing the stop-loss on a case by case basis.