Volatility Based Stop Loss Strategies

Determining where to place your stop loss is one of the biggest hurdles in trading. If you put it too close, you’ll get knocked out by normal market noise. If you place it too far, you are risking more than you really need to.

This is why stop losses based on volatility are useful. Instead of using fixed numbers, they adjust to what the market is actually doing, allowing your trades to have more room to breathe while keeping your risk within predetermined boundaries.

Market Volatility

Markets do not move in straight lines. Prices always rise and fall in waves (also known as momentum). The smart trader has to deal with the inherent volatility of the market in which they trade, and these waves can be smooth to volatile. Volatility is simply a measure of how much price has moved within a given time period. When volatility is relatively high, the swings in price are greater than they are when volatility is lower. 

It is nonsensical to have the same fixed stop loss in both of these scenarios. You may not have a problem using a 20 pip stop in calm market conditions, but in a session with increased volatility, such as a release of major news, you could see the 20 pips be hit in a matter of seconds.  This is why stops based on volatility are useful, as they help you to adapt to changing environments. 

The Essence of Properly Placing Stops in Markets

The basic idea clean cut. Your stop loss should mirror the market's natural "breathing room". You want to avoid being stopped out due to normal price fluctuations in the market, while still protecting yourself in the event the market moves significantly against your trade. Think of it like running on a trail. Your best bet is to leave room around roots and rocks to avoid tripping. 

One of the commonly available means to do this is with the Average True Range (ATR).The ATR displays the average price movement over a period. Many traders will use multiples of ATR (i.e. 1.5x, 2x) to determine where to place stop losses. 

As an example, if the ATR on EUR/USD is 40 pips, a trader will set their stop 60 pips away (1.5 x ATR). The stop is wider than normal, allowing for normal price swings without risking completely.

A Simple Table

Below is what it may look like in practice:

This method scales to the market. In quiet times, the stops are tight. When the market is active, the stops widen automatically.

Avoiding Common Mistakes

A common mistake for traders is mistaking wider stops with more risk. The key is to adjust the size of your position to accommodate that. If your stop is wider because volatility is higher, you simply reduce the size of the lot in order to ensure you are still at the same dollar amount risked.

For example, if you typically risk $100 per trade, you will still risk $100 whether your stop is 30 pips or 80 pips. The only difference is the size of your position. You are essentially adapting to the market without blowing out your risk.

When to Use Volatility Based Stops

These strategies work the best in markets that are known for their sharp price spikes, such as forex during news events, or stocks during earnings season.They are also handy during trending markets where you would want to allow for some room for your trade to ride the wave without getting shaken out.

On the contrary, if the market is extremely flat and quiet, then some traders may prefer to use a more traditional fixed stop or even tight (closer to the entry) in locations. The idea is not to always use volatility blindly, but to know when it provides a distinct advantage.

A Quick Example

Imagine that you're trading gold (XAU/USD), while the ATR is for a movement of 15 dollars. If you buy long at 1900 and use a 2x the ATR stop, at 1870, that your stop is off 30 bucks, if gold dips for a move 10 bucks or 12 bucks it will not matter as that their movements are considered normal volatility. 

But if the market actually reverses and drops for over 30 bucks into your stop range, now your stop is in place and something needs to be done to protect your capital.

This way you can avoid the age-old agony of getting stopped out from "market noise" before the predicted move actually happens.

Combining with Other Strategies

Many traders actually combine a volatility-based stop with other tools as well to achieve the best results. So you could place a stop at 1.5x ATR which also happened to be at a key support or resistance zone. Now you have something to work with. When the stop location conforms to something more significant, that's even more significant. 

Some traders based a trailing stop on volatility and move their stop on the way up, gradually moving their stop as they more their way up as much as the ATR adapts to the market. 

Final Thoughts

Volatility-based stop loss strategies give traders flexible, sensible, and manageable ways of protecting their trade. Using volatility to adjust stop rather than guessing or producing fixed rules gives allows the trader to conform to the markets mood (calm or stormy).

Using this with position sizing further reduces preemptive stop outs and imaging allows the traders' risk to be the same.

If you would like to learn more about how to manage risk and refine your trading strategy, I would suggest checking out/use the Learn section on Wikilix. It is a good place to continue to building knowledge bit by bit, without the guess work.