Setting Stop Losses Using Historical Volatility - Example
In a similar post previously I had explained the basics of Historical Volatility. In this post I will explain how to incorporate it in one's Investment plan by giving an example.
Historical Volatility
Historical Volatility is a measure of price fluctuation over time. It uses historical price data to empirically measure the volatility of a market or instrument in the past. In other words, it is also known as statistical volatility, which is also the standard deviation of day to day price change expressed as annual percentage. In terms of practical implementation in trading, Historical volatility is essentially used to know how a stock has fluctuated in the past and how much likely it is to fluctuate in the future.
Calculation
HV = StandardDeviation(Ln(close/yesterday'sclose), days) *100*Sqrt(number of trading days in year)
where, Days = Length of days (10,20,30,40 .... )
Ln = Natural Logarithm
For e.g A 50 Day HV with 252 trading days in an year would be calculated like this,
HV(50) = Stdev(Ln(Close/Yesterday's close), 50)*100*Sqrt(252)
Example
Let us take two examples here to see how this is done. We will make an assumption that we have picked out 2 stocks out (belonging to same price range) of a method which has positive expectancy and we are ready to invest in them for a period of 50 days each.
The two hypothetical Investments identified are Hind Unilever & Orchid Chemical. Currently the price of HUL is 312.9 & that of Orchid Chemical is 303.85. Now, since we are looking to Invest for a period of 50 day in both of these stocks, we will calculate the 50 day annual Historical Volatility in both by using the formula given above. For Orchid Chemical, we get HV of 66 Rs and for Hindustan Unilever we get HV of 24 Rs.
This means the respective SL for Orchid Chemical and Hind Unilever would be the current market price minus the HV of 50 days.
Orchid = 303.85 - 66 = 237.85
HUL = 312 - 24 = 288
From this example everyone should realize that the more volatile the stock, the deeper SL it requires. The stop loss for Orchid is 20% away from the current price whereas for HUL it is around 8%. This is because Orchid is more volatile than HUL and hence deserves a deeper SL. If this is not considered, one would keep getting stopped out frequently. Now, anyone looking for an Investment can do so by using these stop losses.
Notes
Stop losses based on Historical Volatility are usually appropriate for large sized accounts. Small sized accounts will seriously suffer with this mechanism. Hence one must be aware of which stop loss technique suits which account type. This will come with experience and with more understanding about one's methodology.
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