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

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.)

THE VOLATILITY STOP


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

by Mark Vakkur, M.D.

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.

the system. Mathematically, the volatility stop is


expressed as:
Volatility_Stop =
Close - (average true range of past four weeks) (# true ranges to
subtract from the close)

The greater the number of true ranges, the wider


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

Copyright (c) Technical Analysis Inc.

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

volatility stop cannot go down, only


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

Copyright (c) Technical Analysis Inc.

Next, I tested the system on historical data. The D JIA is a moderately


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.

mization varying the number of average true ranges to subtract


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.

The volatility stop system offers


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

APPLICATION OF THE VOLATILITY STOP SYSTEM


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*

ATR multiplier = The multiple of average true ranges that must be


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.

COMPARISON OF TRADING SYSTEM RESULTS


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.

Copyright (c) Technical Analysis Inc.

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

stop system between 2 and 2.5 ATR factors.


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

Volatility Stop System


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

AVERAGE TRUE RANGE MULTIPLIER

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

Indicator name: Volatility_stop


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

PROGRAMMING AND PLOTTING IN TRADESTATION


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

Indicator formula: MinList ( c[1] +


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.

FIGURE 4: BEST BUY. Trending behavior is captured in the volatility stop


system, here shown with both buy-stops (red) and sell-stops (blue). Neither form
of stop is ever relaxed once started.

Copyright (c) Technical Analysis Inc.

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

So far, it appears that the volatility stop system in the 2-3


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.

AVERAGE TRUE RANGE MULTIPLIER

FIGURE 5: OPTIMIZATION. Optimizing the volatility stop system on the DJIA


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

I finished by applying the system to two mutual funds, Fidelity


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

FIDELITY SELECT ELECTRONICS

2
5
1
0

0.5

1.5

2.5

3.5

4.5

5.5

6.5

AVERAGE TRUE RANGE MULTIPLIER

FIDELITY SELECT ELECTRONICS


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*

FIGURE 7: FIDELITY SELECT ELECTRONICS. ATR multipliers from 2 to 3 work


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

Copyright (c) Technical Analysis Inc.

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

Volatility Stop System


FS Home Finance

36

0.5

1.5

2.5

PROFIT FACTOR

12

42

3.5

4.5

Profit
per trade

AVERAGE TRUE RANGE MULTIPLIER

FIDELITY SELECT HOME FINANCE


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.

The volatility stop system offers an excellent means of defining


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

FIDELITY SELECT HOME FINANCE


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.

Copyright (c) Technical Analysis Inc.

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