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Using Volatility Indicators For Profitable Trade Entry And Exit – Active traders survive because they use initial stop loss protection as well as trailing stops to break even or lock in profit. Many traders spend hours perfecting what they consider the perfect entry point, but few spend as much time creating a sound exit point. This creates a situation where traders are right about the direction of the market, but fail to share in any huge gains because their trailing was hit before the market rallied or broke in their direction. These stops are usually hit early because the trader usually sets them based on chart formation or dollar amount.
The purpose of this article is to introduce the reader to the concept of trailing according to market volatility. In the past
Using Volatility Indicators For Profitable Trade Entry And Exit
Covered the topic of using a volatility stop based on Average True Range (ATR). This article will compare the ATR stop with other volatility stops based on the high, market swing, and Gann angle.
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The three keys to developing a sound exit methodology are determining which volatility indicator to use to properly place a stop, why a stop should be placed this way, and how this particular volatility stop works. This article will also show an example of a trade where volatility stops profit maximization. Finally, to keep the article balanced, I will discuss the advantages and disadvantages of different types of stops.
There are basically two types of stop orders. The trailing stop and trailing stop. The initial stop order is placed immediately after the entry order is executed. This initial stop is usually placed below or above a price level that, if breached, would negate the purpose of being in the trade.
For example, if a buy order is executed because the closing price is above a moving average, then the initial stop is usually placed against the moving average. In this example, the initial stop can be placed at a predetermined point below the moving average.
Another example would be entering a trade when the market has crossed above the swing top and placing an initial stop below the last swing low, or buying an uptrend line with an initial stop below the trend line. In either case, the initial stop is associated with the input signal.
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A trailing stop is usually placed after the market moves in the direction of your trade. Using the moving average as an example, a trailing stop would follow below the moving average as the original entry appreciated in value. For a long position based on a swing chart entry, the trailing stop will be placed below each subsequent higher low. Finally, if a buy signal is generated on an uptrend line, then the trailing stop will follow the trend line to a point below the trend line.
In each instance, the stop was placed at a price based on a predetermined amount below a reference point (ie the moving average, swing and trend line). The logic behind the stop is that if the reference point is breached by a predetermined amount, then the original reason the trade was entered into in the first place is violated. A predetermined point is usually resolved by extensive back testing.
Stops placed like this usually lead to better trading results because, at the very least, they are placed in a logical manner. Some traders enter positions and then set stops based on specific dollar amounts. For example, they go long on a market and stop at a fixed dollar amount below entry. This type of stop is most often guessed because there is no logic behind it. The trader bases the stop on a dollar amount that may have nothing to do with the entry. Some traders feel that this is the best way to keep losses at a consistent level, but in reality, it results in stopping hitting more often.
If you study the market carefully enough, you should be able to notice that every market has its own unique volatility. In other words, it has normal measurable motion. This movement can be with the trend or against the trend. It is most often used in relation to moves that go against the trend. This movement is called market noise. The best trading systems respect the noise, and the best stops are placed outside the noise. One of the best methods of determining market noise is to study market volatility.
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Volatility is basically the amount of movement to be expected from the market over a period of time. One of the best measures of volatility for traders is the Average True Range (ATR). The volatility stop takes a multiple of the ATR, adds or subtracts it from the close, and places the stop at this price. A stop can only move higher during uptrends, lower during downtrends, or sideways. Once a rear station is established, it should never be moved to a worse position.
The logic behind the stop is that the trader accepts the fact that the market will have noise against the trend, but by multiplying this noise as measured by the ATR by a factor of, say, two or three and adding or subtracting from the close, the stop will be kept away from the noise . By completing this step, the trader may be able to hold their position longer, thus giving the trade a greater chance of success.
Other types of stops based on market volatility are stops that are calculated relative to the highest high or lowest low over a period of time, a pivot chart that allows the market to move up and down within a trend, and a Gann angle that moves at a uniform rate of movement in the direction of the trend.
When working with volatility stops, the objectives of the trading strategy should be clearly defined. Each volatility indicator has its own characteristics especially regarding the amount of open profit that is returned in an attempt to maintain the trend.
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This chart shows how different stops would apply to a short position. Four types of stops are used in this example. 20-day high, 20-day average true range 2 plus high, swing chart top, and Gann’s descending angle.
In the image above, the arrows indicate where each of the volatility trailing stations would occur during the normal course of the trade.
Looking at the chart, you’ll notice that the 20-day high is the slowest moving trailing stop and can return the most open profit, but it also gives the trader the best opportunity to capture the biggest part of the downtrend.
The 20-day ATR Stop times 2 + High moves down as long as the market makes lower highs. This stop never moves up, even if the top moves up. It remains at the lowest level reached during the decline. Since it never moves higher, it returns less profit than other stops. The downside of this stop is that it can be executed early in the trend, preventing it from participating in a larger downward movement.
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A Swing Chart follows a market trend defined by a series of lower highs and lower lows. As long as the current high is lower than the previous high, the trade remains active. Once the trend top is crossed, the trade is terminated. This type of volatility stop can return large amounts of open profits depending on the size of the swings. It is the exchange that can allow the trader to participate in a larger move.
The last trailing stop is the Gan corner stop. Gann’s angles start from the highest high just before entering the trade. Gann’s angles in this example move downward at an equal rate of four and eight cents per day. As the market moves down, the distance between the corners increases. This means that the trader can return a large amount of open profits depending on which Gann angle is chosen as the reference point for the lag. Furthermore, the trade may be terminated prematurely if the wrong angle is chosen.
The type of trading system that benefits most from a volatility stop is a trending system. A trader simply uses a trend indicator such as a moving average, trend line or swing chart to determine the trend and then follows the open position using a volatility stop. This type of stop can prevent saws by keeping the stop out of the noise.
Highly volatile or directionless markets are the worst conditions to trade using a volatility stop. Under these conditions, stops are likely to be hit frequently.
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By nature, a trend trading system will always return some of the open profits when used with a lag. The only way to prevent it
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