How it works

The "Limit your losses and protect your gains" rule is the major rule of thumb for any self-respecting businessman. Ignoring it, just as gambling, is a straight way to bankruptcy. Stock market investors know that one of the mechanisms that helps adhere by this rule is the Trailing Stop. The Trailing Stop method allows investors to set a limit on the maximum possible loss without setting a limit on the maximum possible gain, and does not require constant monitoring of their investment.

If you do not have a clear exit strategy, then you have no trade strategy at all. Trailing Stop should probably be the exit strategy to top the investors list of rules. All that would be great, if Trailing Stop hadn't had one flaw: the choice of the optimal percentage, which does not allow to efficiently use Trailing Stop in practice. A -25% percentage on one stock can be a normal state of things and be a disaster on another one. The Adaptive Trailing Stop, which underlies the Sell@Market service, solves that problem. Let's drill down into details to see how it really works...

Contents

1. Introduction
2. Stock volatility
3. Trailing Stop and optimal trailing stop percent problem
4. Adaptive Trailing Stop as solution of the problem
5. Psychology of the investor

1. Introduction

In order to understand the concept underlying Sell@Market, we need to familiarize ourselves with several basic terms it is built upon. If you are a professional market player, you will probably find the explanations below very familiar and simple. Nonetheless, in order to get a full picture, we would like to restate them once again.

We will now see what stock volatility is, provide specific cases, define Trailing Stop and explain its main drawback. We will also suggest using Adaptive Trailing Stop as an alternative and explain how it can solve the problems stemming from the use of Trailing Stop when used as part of our service. Finally, we will touch upon psychological aspects of market trading and explain how you can take them into account when using Sell@Market.

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2. Stock volatility

So what is volatility?

Broadly speaking, Volatility refers to the degree of unpredictable change over time of a certain variable. In our case that variable is stock. Let us not delve into the specifics of volatility calculations, but note that these calculations are performed for a specific time interval. The interval can span from minutes to years, depending on goals and tasks at hand.

Let's consider Intel (INTC) and InterMune (ITMN) to give an example of low and high stock Volatility.

Intel Corporation (Public, NASDAQ:INTC)

InterMune, Inc. (Public, NASDAQ:ITMN)

Volatility of Intel varies from 1% to 1.5% a day while Volatility of InterMune varies from 2% to 3% a day. So, Intel stock is two times less volatile then InterMune stock.

NOTE: Volatility is often viewed as a negative in that it represents uncertainty and risk. Nonetheless, the essence of risk is tightly connected with profitability: the higher the risk is, the higher the expected profits. Therefore, a more volatile stock is more likely to yield revenue, but the probability of loss is also higher.

At Sell@Market, we calculate stock volatility on the daily basis. The reason for that is to react to market changes immediately. It also means that stock Volatility has to be recalculated every day for the purposes stated below.

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3. Trailing Stop and optimal trailing stop percent problem

Let us now find out what Trailing Stop is.

A Trailing Stop order is an order entered with a stop parameter that creates a moving or trailing activation price. This parameter is entered as a percentage change of fall in the security price and is called Trailing Stop percent. See the chart below to learn how Trailing Stop behaves in relation to stock trend and where it generates a signal.

Trailing Stop is fairly popular among traders. Its popularity is backed by the fact that many brokers support Trailing Stop orders. Nevertheless, its main disadvantage is the problem of choosing the optimal percent value. For instance, a -25% percentage on one stock can be a normal state of things and be a disaster on another one. The Adaptive Trailing Stop, which underlies the Sell@Market service, solves that problem. Let's see how.

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4. Adaptive Trailing Stop as solution of the problem

The main difference of the Adaptive Trailing Stop from the regular one is that the Trailing Stop percent depends on the stock Volatility. Therefore, the stop is set to a specific set of volatilities, rather than a definite percentage. For example, if stock volatility is 1% and the stop is set to 10 volatilities, then the stock can fall by 10% before the signal is generated.

To make the Sell@Market service more flexible for our users, we provide three kinds of Adaptive Trailing Stop.

Low risk	Trailing Stop percent is set to 5 volatilities of the stock
Middle risk	Trailing Stop percent is set to 8 volatilities of the stock
High risk	Trailing Stop percent is set to 13 volatilities of the stock

Volatility of the stock is recalculated every market day, and so is that the Trailing Stop percentage. But there is one rule for Trailing Stop percentage recalculation: the Trailing Stop percentage doesn't rise, it only falls. For example, let's consider a middle risk stop. If Volatility for a certain stock equals 1.5% today, we multiply 8 by 1.5% and get 12%, which means we set the Trailing Stop percentage to -12%. If the stock Volatility rises to 1.7% tomorrow , then the Trailing Stop stays at the -12% level, but if Volatility falls to 1.3%, then the Trailing Stop will be recalculated and set to -10.4%.

We will review risk levels and their effects in the next paragraph, and now let's have a look how Adaptive Trailing Stop works on Intel and InterMune stocks. It complies with all the conclusions that have been made above.

Intel Corporation (Public, NASDAQ:INTC)

InterMune, Inc. (Public, NASDAQ:ITMN)

The graphs clearly demonstrate that different stock volatilities correspond to different percentage.

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5. Psychology of the investor

Many traders buy and sell stocks intuitively. But this approach is often a way to bankruptcy, as emotions come into play ("okay, it's falling, but will rise soon"). It is while selling stocks that traders experience the most powerful emotions, often of the negative nature.

Sell@Market offers three target selling prices: low risk, medium risk and high risk. It is expected that you choose the risk level that you need and will follow the stops. Apparently, this is not imperative, but we strongly recommend choosing the acceptable level and adhering to it. While choosing, you should also keep in mind that the lower the risk is, the lower the returns are, and vice versa. Therefore, if you tend towards "saving", the low risk level should be your choice, but if you are ready to assume some risks for higher returns, opt for the high risk level.

Make your choice and let market trading be a pleasure for you, but not a never-ending rollercoaster. A business that you know from A to Z, and a business that gives you confidence in a stable and prosperous tomorrow!

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