The Volatility Stop is a technical indicator that is used by traders to help place effective stop-losses. By using this indicator, traders are able to develop an equilibrium between profiting off trades and controlling risk within the market. Stop-loss needs to be significantly tightened in order to control risk, but it needs to be wide enough to give the market room to breathe in efforts to ensure the trader is not stopped out of the trade too early.
To begin calculations for the Volatility Stop indicator, it is crucial to understand the top three concepts associated with volatility stop-loss: volatility measurement, safety multiple, and price anchor. Let’s analyze these concepts further.
Volatility measurement. Traders first need to choose the way in which they would like to measure volatility. This can be done with a standard deviation.
Safety multiple. By deciding on a safety multiple, traders add a buffer of sorts to the market to filter out noise. In addition, the safety multiple can signal how aggressive a trader is with their placement of stop-loss. For example, the safety multiple could be set at a multiple of 3, but is set based on trader preferences. Having a lower multiple will allow for a tighter stop-loss, with risk control projected able any potential profit. On the other hand, a higher multiple will project a stop-loss with more residual risk, but with larger market breadth. The multiple chosen, therefore has the ability to reflect what the trader expects in terms of price action within the market.
Price anchor. The value that you are left with after deciding the volatility measure and the safety multiple will be the result of your stop-loss distance, specifically regarding price. For example, if you are using a standard deviation of 7 as your volatility measure, and a multiple of 3 as your safety multiple, the product of these values will be 21 (7 x 3 = 21). Next, choose your price anchor. For example, this can be the last closing price.
The most common price anchors are listed as price bar highs, lows, and closes. In addition, Moving Averages (MAs) can also be used by traders as the price anchor. When entering a long- or short-position, setting the price anchor as the bar high or bar low, respectively, could project a tighter stop-loss. By using the closing price as the price anchor, traders will get a smoother result.
The stop-loss distance can be determined by the value chosen from the anchor price. This will help traders ultimately determine where to place the stop-loss. The placement depends on the trader’s position (long or short position). From here, you subtract the product of the standard deviation value and the safety multiple from the price anchor value.
There are many different volatility stop-loss methods out there to help traders find that distinct balance between profit and risk management. Let’s analyze a select few and see how strategies can come out of identifying the three key components of the Volatility Stop indicator listed in the Calculations section.
Bollinger Bands. The Bollinger Bands indicator relies on standard deviation for both calculation and execution and is therefore a great tool to use in tandem with the Volatility Stop. The lower band can work particularly well as a stop-loss for a long position, although the indicator was not intended to aid stop-loss. The bands widen when volatility is reportedly high, and therefore traders should be mindful of the indicator’s projections, especially when the bands are moving away from price.
Keltner Bands. The Keltner Bands indicator is similar to Bollinger Bands, however it relies on Average True Range (ATR), rather than standard deviation.
What to look for
Stop-losses can be managed by and occasionally based on price patterns, but also rely on support and resistance to function. Traders may not always be able to find proper price action formations when attempting to place stop-losses. However, stop-losses can always be placed based on volatility, which is why Volatility Stop can be such a key indicator. The methods and strategies available to traders using Volatility Stop are also objective and easy to program, which makes it even more beneficial for traders who rely on algorithmic analysis.
One more thing to keep in mind is traders should carefully place stop-losses and consider placement to be a high priority when using this indicator. Placement should not be randomized, rather well thought out and considered. In other words, stop-loss placement is crucial.
The Volatility Stop indicator does come with a few drawbacks, one of which being that a trader must adjust input parameters. These parameters can be set to default, or adjusted by the trader given their preference.
Those using the indicator often assume that current and future market volatility are rooted in historical volatility and therefore will follow suit. However, this is not always the case, and traders should be aware of the fact that historical volatility analysis may not affect current and future stop-losses.
The Volatility Stop indicator helps place effective stop-losses to develop an equilibrium between profiting off trades and controlling market risk. Stop-loss needs placement is significant and should not be randomized. This helps minimize risk. Traders should also keep in mind that using other indicators in addition to Volatility Stop will be helpful in achieving the overall goal of profit and risk management.