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Maximize Profits With Volatility Stops

Active traders survive because they use stop loss protection as well as trailing stops to break even or to lock in profits. Many traders spend hours perfecting what they consider to be the perfect entry point, but few spend the same amount of time creating a solid exit point. This creates a situation where traders are right about the direction of the market, but fail to participate in huge gains because their trailing stop was hit before the market rallied or broke in their direction. These stops are usually hit prematurely because the trader usually places them based on a chart formation or dollar amount.

The purpose of this article is to introduce the reader to the concept of placing a stop loss based on market action. volatility. In the old days Investopedia covered the topic of using a volatility stop based on the mean true range (ATR). This article will compare the ATR stop to other volatility stops based on the high, the market swing and a Gann angle.

Key points to remember

  • Traders can use volatility indicators to help them create stops that allow them to exit trades and maximize profits.
  • The average true range (ATR) is an indicator of market volatility usually derived from the simple 14-day moving average of a series of true range indicators.
  • A volatility stop takes a multiple of the ATR, adds or subtracts it from the closing price, and places the stop at that price.
  • Other types of market volatility stops include stops that are calculated by reference to a high or low over a period of time, a swing chart that allows the market to move up and down within a trend, and a Gann angle that moves at a uniform rate of speed in the direction of the trend.

Output methodology

The three keys to developing a solid exit methodology are determining what volatility indicator to use for proper stop placement, why the stop should be placed that way, and how that particular volatility stop works. This article will also show an example of a trade where volatility stops maximized profits. Finally, to keep the article balanced, I will discuss the pros and cons of the different types of stops.

Initial stop

There are basically two types of stop orders. The initial stop and the trailing stop. The initial stop order is placed immediately after the execution of the entry order. This initial stop is usually placed below or above a price level which, if violated, would negate the purpose of being in the trade.

For example, if a buy order is executed because the the last price was above a moving average, the initial stop is usually placed in reference to 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 a swing top and place the initial stop below the last swing low or buy on an uptrend line with an initial stop below the trendline. In each case, the initial stop is tied to the input signal.

Trailing stop

A trailing stop is usually placed after the market has moved in the direction of your trade. Using the moving average as an example, a trailing stop would trail below the moving average as the original entry gains value. For a a long position based on the swing chart entry, the trailing stop would be placed below each subsequent higher bottom. Finally, if the buy signal was generated on an uptrend line, a trailing stop would follow the trendline at a point below the trendline.

Determining a volatility stop

In each example, the stop was placed at a price based on a pre-determined amount below a reference point (i.e., moving average, swing, and trendline). The logic behind the stop is that if the benchmark is breached by a pre-determined amount, the original reason the trade was executed in the first place has been breached. The predetermined point is usually decided by extensive backtesting.

Stops placed in this manner generally lead to better trading results because, at a minimum, they are placed logically. Some traders enter positions and then place stops based on specific dollar amounts. For example, they go long in a market and place a stop at a fixed dollar amount below the entry. This type of stop is usually hit the most often because there is no logic behind it. The trader bases the stop on a dollar amount which may have nothing to do with the entry. Some traders think this is the best way to keep losses constant, but in reality it results in more frequent stops.

If you study a market closely enough, you should be able to observe that each market has its own volatility. In other words, it has normal measurable movement. This move can be with the trend or against the trend. Most often, it is used in reference to counter-trend movements. This movement is called a market noise. The best trading systems respect noise, and the best stops are placed outside of noise. One of the best methods to determine the noise of a market is to study the volatility of a market.

What to expect

Volatility is basically the amount of movement to expect from a market over a certain period of time. One of the best measures of volatility that traders can use is the Average True Range (ATR). A volatility stop takes a multiple of the ATR, adds or subtracts it from the close, and places the stop at that price. The stop can only go up during uptrends, down during downtrends or sideways. Once the trailing stop has been established, it should never be moved to a worse position.

The logic behind the stop loss is that the trader accepts the fact that the market will have noise against the trend, but multiplying that noise as measured by the ATR by a factor of, say, two or three and adding it or subtracting it from the near, the stop will be kept away from the noise. By completing this step, the trader may be able to hold their position longer, giving the trade a better chance of success.

Other types of stops based on market volatility are stops that are calculated by reference to a high or low over a fixed period of time, a swing chart which allows the market to move up and down inside a trend, and a Gann angle which moves at a uniform speed in the direction of the trend.

Volatility Stop Examples

When working with volatility stops, it is necessary to clearly define the objectives of the commercial strategy. Each volatility indicator has its own characteristics, especially with regard to the amount of open profit that is returned in order to stay in the trend.

2009 May Soya.
Image by Sabrina Jiang © Investopedia 2020

This table shows how various stops would be applied to a short position. There are four types of trailing stops used in this example. Last 20-day high, 20-day average true range multiplied by 2 plus high, swing chart top and downside Gann angle.

Image by Sabrina Jiang © Investopedia 2020

In the figure above, the arrows indicate where each of the Trailing Volatility Stops would have been executed during the normal course of the trade.

20 day high

Looking at the chart, one will observe that the 20-day high stop is the slowest trailing stop and can restore the most open profits, but also offers the trader the best opportunity to capture most of the breakouts. downtrend.

20 day ATR

The 20-day ATR downtimes 2+ high goes down as long as the market makes lower highs. This stopper never goes up even if the spindle moulder goes up. It remains at the lowest level reached during the decline. Because it never rises higher, it returns less profit than the other trailing stops. The downside of this stop is that it can be executed at the beginning of the trend, thus preventing participation in a larger bearish move.

Oscillating chart

The Swing Chart follows the market trend as defined by a series of lower highs and lower lows. As long as the current high is below the previous high, the trade remains active. Once a trend top is breached, the trade is stopped. This type of trailing volatility stop can yield large amounts of open profit depending on the magnitude of the swings. The trade-off is that it may allow the trader to participate in a larger move.

Gann angle

The last trailing stop is the angular Gann stop. Gann angles start from the high just before the trade entry. The Gann angles in this example descend at a uniform rate of four and eight hundred per day. As the market goes down, the distance between the angles widens. This means that the trader can return a large amount of open profit depending on the Gann angle chosen as the reference point for the trailing stop. Additionally, a trade can be aborted prematurely if the wrong angle is chosen.

The type of trading system that benefits the most from a volatility stop is a trending system. The trader simply uses a trend indicator such as a moving average, trendline or swing chart to determine the trend, then trail the open position using a volatility stop. This type of stop may be able to prevent scroll saws by keeping the stop outside of the noise.

Highly volatile or directionless markets are the worst conditions to trade in using a volatility stop. Under these conditions, stops are likely to be hit frequently.

The essential

By nature, a trend trading system will always return a portion of the open profits when used with a trailing stop. The only way to avoid this is to set profit targets. However, setting profit targets can limit the amount of gains on the trade. Some volatility-based trailing stops can prevent capturing a big trend if the stops are moved too frequently. Other volatility-based trailing stops can “turn” too much open profit. By studying and experimenting with these different forms of trailing stops, you can optimize the stop that best meets your trading objectives.

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