Volatility Stop System for Trading

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Volatility Stop System for Trading

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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.)

If Im going long, the volatility stop is constructed by

starting with the entry bars close and subtracting a

multiple of average true range. I use a four-week

averaging period and vary the number of multiples of

average true range to subtract when Im optimizing

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.

expressed as:

Volatility_Stop =

Close - (average true range of past four weeks) (# true ranges to

subtract from the close)

your stop, and the more willing you are to let prices

swing before declaring a change in trend.

An additional necessary modification is that the

Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.

up or sideways, unless penetrated by

the bars low. For details, see sidebar

Programming and plotting in

TradeStation, in which I show the

results of optimizing the system for

the Dow Jones Industrial Average

(DJIA), some stocks, and some mutual funds.

If you are going short, construct a

volatility buy-stop using a multiple

of average true ranges above the

close. Simply add to the close the

product of average true range multiplied by the number of ranges. This

indicator must not go up unless penetrated by the last bars high, at

which point youd be stopped out.

Here, however, I will only use the

volatility sell-stop, weekly bars,

and a four-week lookback period.

The same principles apply in any

time frame.

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

trendworthy market and has been

particularly since 1982, when it

broke out of a trading range that it

had entered back in 1968. If my

system is any good at identifying

and catching trends, it should do

just that with the DJIA .

To apply the system, I ran an opti-

Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.

from the close from 0.50 to 2.50 by increments of 0.5. I

anticipated that the lower the average true range factor (the lower

the number of average true ranges required to generate the sell

stop), the higher the number of trades, with many trades stopping

out for a small loss. As it turned out, this assumption was correct,

as Figure 1 shows.

an excellent means of defining and

capturing major market moves. It

appears robust across an array of

assets and multiplier values.

The system is profitable across all parameter values, indicating that our idea may be robust. Second, the profitability was

relatively stable, showing an overall trend toward greater

profitability as the value of the average true range (ATR) factor

was increased. Third, the smaller the ATR multiplier, the

greater the number of trades and the less average profit per

trade. Finally, the profit factor (the ratio of gross profit to gross

loss) also increases as we increase the ATR factor.

Whenever we think we have a good system, we should ask

ourselves, Compared to what? A poor mans test for comparability to buy and hold is to subtract the price of the asset at the

end of the period from the price at the beginning of the period

and compare it to the total number of points earned by the

system. In this example, the best case of 4,603 does not

compare favorably with the 7,100-point gain of the DJIA during

that period.

However, this was a historically aberrant period for the DJIA,

so comparisons to buy and hold during this period would be

tough to beat. In addition, though not shown, this 4,603-point

gain was made with substantially less risk than buy and hold.

For comparison to another trading system, I compared the

volatility stop system with the simple channel breakout system

I presented in my April 1999 STOCKS & COMMODITIES article.

The rules for channel breakout are simple: If this weeks close

is greater than the 12-week exponential moving average (EMA),

then buy-stop at this weeks high and exit long at the trailing

three-week low on a stop.

The rules for the moving average convergence/divergence

(MACD) are more complex. If the 12-week/26-week 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 in

Figure 2.

Not only is the volatility stop system more profitable than the

channel breakout system for ATR factors greater than 1, but it

requires far fewer trades (from 34 to 16 compared with 50 for

the channel breakout system) to capture the profits. The result

of the MACD system is comparable to the profit of the volatility

TO THE DJIA, FEBRUARY 1988 TO DECEMBER 1998

ATR

multiplier

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*

penetrated to declare the end of an uptrend

n = Number of trades

Percentage = Percent profitable

Profit/trade = Average profit per trade, winners and losers, ignoring

slippage, commissions dividends and interest earned while in cash

* = Greatest value in each column.

FIGURE 1: To apply the system, Vakkur ran an optimization varying

the number of average true ranges to subtract from the close from

0.50 to 2.50 by increments of 0.5. He anticipated that the lower the

average true range factor (the lower the number of average true

ranges required to generate the sell stop), the higher the number of

trades, with many trades stopping out for a small loss. As it turned

out, this assumption was correct, as Figure 1 shows.

System

Net

Profit

n

profit

factor

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.

Satisfied with the DJIA results, next I tested the system on

stocks and mutual funds.

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

Best Buy

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

Inputs: ATR_len(4), ATR_fac(2)

Volatility_Stop = MaxList ( c[1] AvgTrueRange(ATR_len)*ATR_fac, iff(l[1] < plot1[1], 0,

plot1[1]))

35

-5

You can plot the volatility stop easily in TradeStation. You

should offset the indicator by a week, using the last bars

close to generate this weeks bars plot, since the value of

this weeks close wont be known until the end of the week.

For plotting purposes, Ive added a conditional check to

determine if price penetrated the indicator, and if not, then to

ensure that the calculated value for this bars sell-stop is not

less than the previous value of the volatility sell-stop. Here

is the TradeStation EasyLanguage for when you are only

long stock:

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

AvgTrueRange(ATR_len)*ATR_fac,iff(h[1] > plot1[1], c*2,

plot1[1]))

This should look familiar with one modification; the only

difference is that you use the last bars high and are now

interested in knowing if it is greater than last bars volatility

buy stop (h[1] > plot1[1]). If so, use the calculated value:

average true range times the average true range factor

(ATR_fac) plus the close. Use this value, since the indicator

will use the minimum (MinList) of the calculated value and

double the close, which will be greater than the calculated

value, so will be discarded.

On the other hand, if last weeks high is not greater than

the last weeks volatility buy-stop, then last weeks volatility

buy-stop (plot1[1]) is compared to the calculated value to

determine which is less. This will prevent the indicator from

going down unless penetrated by last bars high. M.V.

system, here shown with both buy-stops (red) and sell-stops (blue). Neither form

of stop is ever relaxed once started.

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

multiplier range gives solid results. This is reassuring, since

the DJIA and Best Buy behave quite differently. This illustrates the advantage of a system that inherently adapts itself

to different assets and market conditions, since it is the

multiple of a measure of the volatility of the asset and not

some arbitrary value.

Looking for another stock that has demonstrated welldefined uptrends and downtrends turned up Micron Technology [MU], which is both volatile and cyclical. Results are

summarized in Figure 5. Once again, the system is profitable

across a range of multipliers, which should reassure us that the

premise of our trading system is robust.

Once again, the 2-3 range is profitable. The volatility stop

system with values of 2-3 ATM factors offers a nice balance

between how much movement is significant and how much

money the investor is willing to lose by being stopped out.

For comparison purposes, I checked the other two systems

on Micron, as can be seen in Figure 6.

Although the channel breakout system manages to capture

more net profits, its profitability per trade is less than the

volatility system. It took 51 trades to capture the profits that the

volatility stop system, with a multiplier of 3, caught in 15 trades.

After taking commissions and slippage into account, which this

testing did not, as well as psychological wear and tear, the

volatility stop system would most likely be more effective.

showed that an ATR multiplier of 2.5 worked best, though there was a broad

range of profitability.

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

Select Electronics and Fidelity Select Home Finance. Again, if

ones trading system is robust, it should not matter whether it

is applied to soybeans or Microsoft, stocks or mutual funds. By

their nature, mutual funds differ from individual stocks only in

that their moves tend to be less volatile, since their volatility

represents the aggregate volatility of the individual assets in the

portfolio. In other words, the behavior of mutual funds resembles that of an index.

The major disadvantage of trading mutual funds is that stoploss orders cannot be entered mechanically; you must monitor

the assets yourself and only exit the day after a sell signal,

unless you successfully anticipate a close below a given level,

which is possible if you know the performance of an index or

basket of stocks with which the mutual funds is highly correlated, and in most cases you cannot exit intraday. (The Select

funds offered by Fidelity are an exception to the latter disadvantage, allowing hourly pricing and trading.)

Repeating the process and comparing the results of the three

systems I have been using for Fidelity Select Electronics gives

us the results of Figure 7.

The volatility system is superior in all counts except for

percentage profitability (all systems are comparable in this

regard). It is not only more profitable, but it is so with fewer

trades, leading to a higher profit per trade. (The multiplier of 2

was arbitrarily chosen, not optimized.) In addition, Figure 7

shows that the volatility stop system remains stable across

different values of the ATR multiplier.

NET PROFIT

2

5

1

0

0.5

1.5

2.5

3.5

4.5

5.5

6.5

System

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*

well again when tested on FSEAX. Values above 6.5 produced no losses and

therefore arent comparable.

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

FS Home Finance

36

0.5

1.5

2.5

PROFIT FACTOR

12

42

3.5

4.5

Profit

per trade

System

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.

and capturing major market moves. It appears robust across an

array of assets and multiplier values. It is intuitively appealing

because it adjusts itself to different markets and assets. It

usually generates fewer trades than the simple channel breakout

but generally seems to have comparable profitability, resulting

in a much higher average profit per trade.

In a real-world situation where psychology, commissions,

and slippage take their toll, the volatility stop system is probably superior to a channel breakout system. In most cases, the

MACD system tended not to capture as much profit as the

volatility stop system. Of the three, the MACD is the most

abstract indicator, since it is a derivative of a derivative of

price; the more profitable breakout systems are based more

directly on price itself. Once again, this underscores the adage

of Keep it simple!

Mark Vakkur is a psychiatrist and a stock trader.

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

The final asset to which I would like to apply the volatility stop

system is Fidelity Select Home Finance. This security is not

well correlated with the technology sector (as the other assets

are), but represents an interest ratesensitive collection of

financial stocks. Figure 8 shows how the volatility stop system

performed.

Once again, the volatility stop system is superior in terms of

net profitability and profit/trade compared with the channel

breakout system. The MACD system, however, appears superior to the others in terms of profit factor and profit per trade;

however, it does not capture as much total profit. See Figure 8

for a somewhat higher peaking of the profit factor than in

previous tests (at 3.5), although the 2-3 ATR multiplier area is

respectably profitable.

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