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Volatility Stop System
Volatility Stop System
SYSTEM DESIGN
The Volatility
Stop System
Heres a step-by-step through the development of a
robust trading system for capturing major market
moves.
olatility systems have a long
and honored history in technical trading. Here, Ill show you
a simple, robust version you
can use on a weekly basis. I
include code in a sidebar and
show the results of optimizing
the system for the Dow Jones Industrial Average
(DJIA), some stocks, and some mutual funds. The
results are good across the board.
The most robust systems adapt themselves to the
market or security being traded. One indicator particularly well suited to the intermediate-term trader
or investor is what I refer to as the volatility stop. The
volatility stop is based on the idea that a trading stop
should be adjusted for an assets volatility, here
measured as the average true range. (For more on
true range, see the sidebar.)
TRUE RANGE
The volatility stop system assumes that an assets future
volatility will most likely be correlated with its recent past
volatility. There are many ways to define volatility, but
perhaps the simplest is by measuring the swing of an asset
from highest high to lowest low over a given period that
is, you measure the price range. The only wrinkle here is that
prices can gap up or down and not fill the gap. To handle
these gaps, first you check to see whether gaps have
occurred and correct for it. The resulting indicator is the true
range.
To use an example, lets say that our stock with a 20-100
price range closed on Monday at 100, then released miserable earnings after the closing bell. If the stock opened on
Tuesday at 50, which turns out to be the daily high, then
closes at 40, the stocks daily range is only 10 points (50-40),
but its true range is 60 (the true high of 100 minus the true
low of 40). In this case, the stocks daily range would grossly
understate its volatility.
Mathematically, the true high is defined as the greater of
this bars high and yesterdays close. The only time that
yesterdays close would be greater is if the stock gapped
down, in which case measuring the distance from yesterdays
close to todays low would be more meaningful and more
representative of the stocks price swing than measuring the
difference between the intraday high and low. Similarly, the
true low is defined as the lesser of todays low and yesterdays
close. It follows that the true range is the greatest difference
between
1 Todays high and todays low, or
2 Todays high and yesterdays close, or
3 Todays low and yesterdays close.
The average true range just averages the values for each
bar for the number you choose, which can be any period.
Using a four-bar averaging period would average the true
range of each bar over the last four bars.
Considered graphically, the average true range, in most
cases, equals the average height of each bar in a bar graph
over the averaging period.
By using this measure of volatility, the volatility stop
system is responsive to the behavior of the trading asset.
M.V.
Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.
THE SYSTEM
I combine the volatility sell-stop
with a simple breakout buy-stop and
a moving average filter, long only.
The entry is: if this weeks close is
greater than the 12-week exponential moving average of the closes,
then buy at this weeks high plus
one tick on a stop. The moving
average filter is a crude screen of
intermediate- to long-term trend to
avoid entering the market during a
sustained downtrend.
Exit the long position at the volatility stop on a stop. And thats it.
The system is designed to catch
any trends and eventually get out
on a stop that constantly adjusts for
the actual volatility of the trading
vehicle.
BRAD WALKER
THE DJIA
Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.
Net
profit
Profit
factor
0.50
1.00
1.50
2.00
2.50
2153
2455
4082
3555
4603*
1.58
1.73
3.60
2.80
6.08*
Profit
per trade
98*
64
34
25
16
42
47
47
44
63*
21.97
38.37
120.06
142.21
287.70*
Profit
per trade
Channel brkout
MACD
Volatility stop
38
71
63*
$54
$249
$288
$2713
$4232
$4603*
2.01
12.25
6.08*
50
17
16
FIGURE 2: The rules for the MACD are more complex. If the 12-week/26week exponential moving average MACD is greater than its six-week
exponential moving average, then buy at this weeks high stop. If long, place
a sell-stop at this weeks low if the MACD drops below its six-week EMA. For
all of the systems, long and flat were the only possible positions. The results
can be seen here.
FIGURE 3: BEST BUY. Best Buy has had dramatic ascents followed by brutal selloffs.
Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.
BEST BUY
Best Buy (Figure 3) has had dramatic ascents followed by brutal
selloffs. If a trend-following system cannot make money with Best
Buy, then we should question the
ability of the system to identify
and exploit trends.
So how did the volatility stop
system perform with Best Buy?
As it turns out, quite well (Figure
4) from January 1990 to November 1998. Profits peak with
stops around 2.5 times average true range, then drop off
sharply as we increase beyond 3. As it turned out, 2.5 was also
the optimal number for total profit, profit factor, percent of
trades profitable, and average profit per trade. Just as with the
DJIA, the smaller the multiplier, the more trades generated,
and the less profit per trade. The results of the channel
breakout and MACD systems on Best Buy for the same period
can be seen in Figure 4.
The tradeoff here is between total profit and efficiency in
terms of number of trades and profit per trade. This is important, since commissions and slippage ignored here would
take a much bigger toll on the channel breakout system than on
the volatility stop system. The MACD system seems to be less
effective in all respects except percent profitability.
9
50
45
40
NET PROFIT
25
20
15
10
2
5
1
0
0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10
Channel breakout
MACD
Volatility stop
Where:
ATR_len = number of bars to use for averaging of
the true range, initially set to 4
ATR_fac = the multiple of average true ranges to
add or subtract from the close, initially set to 2.
Working from inside out, the indicator first checks if the last
bars low penetrated (was less than) last bars value of the
volatility stop, in which case the indicator by default would be
assigned the calculated value, c[1] (last bars close) minus
the product average true range times the average true range
factor (ATR_fac). (This occurs since a zero would be returned, which when compared to the computed value would
be less, so the function MaxList would return the calculated
value.) If the last bars low did not penetrate the volatility
stop, then the last bars volatility stop is returned (plot1[1]),
which is then compared to the computed value; the maximum of the two (MaxList) is assigned to the indicator.
The EasyLanguage formula for the short version is:
Indicator name: c_plus_vol:
PROFIT FACTOR
30
System
35
-5
Net
profit
Profit
factor
Profit
per trade
50.95
26.69
42.87
6.15
3.87
7.64
25
14
12
56
64
58
2.04
1.91
3.57
Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.
60
Micron Technology
NET PROFIT
50
40
30
20
10
-10
0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10
PROFIT FACTOR
MICRON TECHNOLOGY
System
Net
profit
Channel brkout
71.17
MACD
17.89
Volatility stop*
47.81
*Average true range multiplier = 3
Profit
factor
3.75
1.42
5.82
51
30
15
51
37
60
Profit
per trade
1.40
0.60
2.14
FIGURE 6: Compared to the DJIA, a slightly higher value of the ATR multiplier,
3.0, works well for Micron Technology.
30
Volatility Breakout
FSEAX
25
20
5
4
15
3
10
PROFIT FACTOR
NET PROFIT
2
5
1
0
0.5
1.5
2.5
3.5
4.5
5.5
6.5
Net
profit
Profit
factor
MACD
15.45
2.21
Channel brkout
23.03
3.68
Volatility stop*
24.98*
7.31*
*Average true range multiplier = 2
n
13
29
16
%
46
52*
50
Profit
per trade
1.19
0.79
1.56*
Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.
SUMMARY
18
46
16
44
14
NET PROFIT
10
40
8
6
38
34
36
0.5
1.5
2.5
PROFIT FACTOR
12
42
3.5
4.5
Profit
per trade
Net
profit
Profit
factor
Channel brkout
34.97
4.27
MACD
34.05
15.55
Volatility stop
36.86*
5.86
*Average true range multiplier = 2
n
34
14
23
65
79
78
1.03
2.43
1.60
FIGURE 8: ATR multipliers in the range of 3.5 to 4.0 are somewhat higher for this
sector fund, indicating the volatility stop is sensitive to the tradables behavior.
RELATED READING
Aan, Peter [1989]. Volatility System, Technical Analysis of
STOCKS & COMMODITIES, Volume 7: July.
Vakkur, Mark [1999]. Channel Breakout System, Technical
Analysis of STOCKS & COMMODITIES, Volume 17: April.
See Traders Glossary for definition
S&C