Average True Range

Average True Range is an indespensable tool for designers of good trading systems. It is truly a workhorse among technical indicators. Every systems trader should be familiar with ATR and its many useful functions. It has numerous applications including use in setups, entries, stops and profit taking. It is even a valuable aid in money management.

The following is a brief explanation of how ATR is calculated and a few simple examples of the many ways that ATR can be used to design profitable trading systems.

How to calculate Average True Range (ATR).

Range: This is simply the difference between the high point and the low point of any bar.

True Range: This is the GREATEST of the following:
1. The distance from today's high to today's low
2. The distance from yesterday's close to today's high, or
3. The distance from yesterday's close to today's low

True range is different from range whenever there is a gap in prices from one bar to the next.

Average True Range is simply the true range averaged over a number of bars of data.

To make ATR adaptive to recent changes in volatility, use a short average (2 to 10 bars). To make the ATR reflective of "normal" volatility use 20 to 50 bars or more.

Characteristics and benefits of ATR.

ATR is a truly adaptive and universal measure of market price movement.
Here is an example that might help illustrate the importance of these characteristics:

If we were to measure the average price movement of Corn over a two day period and express this in dollars it might be a figure of about $500.00. If we were to measure the average price movement of a Yen contract it would probably be about $2,000 or more. If we were building a system where we wanted to use the set appropriate stop losses in Corn and Yen we would be looking at two very different stop levels because of the difference in the volatility (in dollars). We might want to use a $750 stop loss in Corn and a $3,000 stop loss in Yen. If we were building one system that would be applied identically to both of these markets it would be very difficult to have one stop expressed in dollars that would be applicable to both markets. The $750 Corn stop would be too close when trading Yen and the $3,000 Yen stop would be too far away when trading Corn.

However, let's assume that, using the information in the example above, the ATR of Corn over a two day period is $500 and the ATR of Yen over the same period is $2,000. If we were to use a stop expressed as 1.5 ATRs we could use the same formula for both markets. The Corn stop would be $750 and the Yen stop would be $3,000.

Now lets assume that the market conditions change so that Corn becomes extremely volatile and moves $1,000 over a two day period and Yen gets very quiet and now moves only $1,000 over a two day period. If we were still using our stops as originally expressed in dollars we would still have a $750 stop in Corn (much too close now) and a $3,000 stop in Yen (much too far away now). However, our stop expressed in units of ATR would adapt to the changes and our new ATR stops of 1.5 ATRs would automatically change our stops to $1500 for Corn and $1500 for Yen. The ATR stops would automatically adjust to the changes in the market without any change in the original formula. Our new stop is 1.5 ATRs the same as always.

The value of having ATR as a universal and adaptive measure of market volatility can not be overstated. ATR is an invaluable tool in building systems that are robust (this means they are likely to work in the future) and that can be applied to many markets without modification. Using ATR you might be able to build a system for Corn that might actually work in Yen without the slightest modification. But perhaps more importantly, you can build a system using ATR that works well in Corn over your historical data and that is also likely to work just as well in the future even if the nature of the Corn data changes dramatically.

Average True Range

This is the second in a series of articles about using Average True Range. In our first article in Bulletin 10 we explained how ATR is calculated and gave an overview of its many uses and benefits. In this article we will show some
specific examples of how using ATR can help to make our systems more robust.

First lets look at a simple buy only system for Corn without using ATR. Here are the rules:

1. Buy Corn whenever it rises 4 cents per bushel from the opening price.
2. Take a profit whenever the profit reaches 18 cents per bushel.
3. Take a loss whenever the loss reaches 6 cents per bushel.

Now lets build the same system using ATR. (Assume that the 20 day ATR is 6 cents).

1. Buy when the price rises 0.666 ATRs from the open.
2. Take a profit when the profit reaches 3 ATRs.
3. Take a loss whenever the loss reaches 1 ATR.

We have the original system and a modified version that has substituted ATR for the important variables. The two systems appear to be almost identical at this point. They both will enter and exit at the same prices. Now let's
assume that the market conditions change and the Corn market becomes twice as volatile so that the ATR is now 12 cents per day instead of 6 cents. Here is a comparison of the original system and the ATR system:

1. The original entry of 4 cents per bushel from the open is now too sensitive. It will generate too many entry signals since the daily range is now 12 cents instead of only six cents.

However, the entry expressed as 0.666 ATRs will adjust automatically and will now require the price to move 8 cents per bushel to enter. The frequency and reliability of our entries remains the same as before.

2. The original profit objective of 18 cents per bushel is much too close for a market that is now moving 12 cents per day. As a result the profits will be taken too quickly and our original system will be missing many opportunities
to make much bigger profits than usual.

However the profit target expressed as 3 ATRs has automatically expanded the profit objective per trade to 36 cents per bushel. Significantly larger profits are now being realized by the ATR system as a result of the increased
volatility.

3. The original stop loss of 6 cents per bushel will now be hit frequently in a market that is moving 12 cents per day. If you combine these frequent stop loss exits with the overly frequent entries being generated, you have a classic “whipsaw” situation and we can expect to encounter a severe string of losses. Our original system is now failing because the market conditions have changed. We need to fix it or abandon it in a hurry.

However lets look at our ATR version of the system. The stop loss expressed as 1 ATR now sets our stop farther away at 12 cents so it isn’t being hit any more frequently than before. We continue to have the same percentage of winning trades only the winning trades are much larger than before thanks to an increased profit objective. Our ATR system has a nice series of unusually large winning trades and is currently making a new equity peak. The ATR system now looks better than ever.

In our example, the proper application of ATR has made the difference between success and failure.

In our next bulletin we will look at a few more of the many ways we can apply ATR in our trading systems.

Average True Range

This is the third in a series of articles about using Average True Range. In our first article in Bulletin #10 we explained how ATR is calculated and gave an overview of its many uses and benefits. In Bulletin #12 we showed some
specific examples of how using ATR can help to make our systems more robust. In this Bulletin we will show some of our favorite applications of ATR as part of our entry logic.


Sample Applications of ATR as an entry tool:

Entry Setups: (Remember, entry setups tell us when a possible trade is near.
Entry triggers tell us to do the trade now.)

Range contraction setup: Many technicians have observed that big moves often emerge from quiet sideways markets. These quiet periods can be detected quite easily by comparing a short period ATR with a longer period ATR. For example if the 10 bar ATR is only .75 or less of the 50 period ATR it would indicate that the market has been unusually quiet lately. This can be a setup condition that tells us an important entry is near.

Range expansion setup: Many technicians believe that unusually high volatility means that a sustainable trend is underway. Range expansion periods are just the opposite of the range contraction periods. Range expansion
periods can be measured by requiring that the 10 bar ATR be some amount greater than the 50 period ATR. For example the 10 bar ATR must be 1.25 or more times the 50 period ATR.

If you are concerned about the apparent contradiction of these two theories we could easily combine them. We could require that a period of low volatility be followed by a period of unusually high volatility before looking for our entry.

Dip or rally setup: Lets assume that we want to buy a market only after a dip or sell it only after a rally. We could tell our system to prepare for a buy entry whenever the price is 3 ATRs or more lower than it was five days ago. Our setup to sell on a rally would be that we want to sell short only when the price is 3 ATRs or more higher than it was five days ago. The choice of 3 ATRs and five days is simply an example and isn’t necessarily a recommended choice of parameters. You will have to figure out the proper parameters on your own depending on the unique requirements of your particular system.

Entry Triggers:

Volatility Breakout: This theory assumes that a sudden large move in one direction indicates that a trend in the direction of the breakout has begun. Normally the entry rule goes something like this: Buy on a stop if the price rises 2 ATRs from yesterday’s close. Or sell short on a stop if the price declines 2 ATRs from the previous close. The general concept here is that on a normal day the price will only rise or fall 1 ATR or less from the previous close. Rising or falling 2 ATRs is an unusual occurrence and indicates that something out of the ordinary has influenced the prices to cause the breakout. The inference is that whatever caused this breakout has major importance and a new trend is beginning.

Some volatility systems operate by measuring the breakout in points rather than units of ATR. For example the system may require that the Yen must rise 250 points from the previous close to signal a breakout to the upside. Systems measuring points rather than units of ATR may need frequent reoptimization to stay in tune with current market conditions. However, breakouts measured in units of ATR should not require reoptimization because, as we previously explained, the ATR value contracts and expands with changing market conditions.

Change in direction trigger: Lets assume that we want to buy a dip in a rising market. We combine the dip or rally setup described above with an entry trigger that tells us the dip or rally may be over and the primary trend is resuming.

The series of rules might read something like this: If the close today is 2.0 ATRs greater than the 40 day moving average (this condition establishes that the long term trend is still up) and the close today is 2 ATRs or more below the close seven days ago (this condition establishes that we are presently in a dip within the uptrend) then buy tomorrow if the price rises 0.8 ATRs above todays low. This entry trigger shows that we have rallied significantly from a recent low and that the dip is probably over. As we enter the trade the prices are again moving in the direction of the major trend.

As you can see, the ATR can be a most valuable tool for designing logical entries. In our next article we will discuss using ATR in our exit strategies and give some interesting examples.

Using Average True Range for Exits

This is the fourth in a series of articles about using Average True Range. In our first article in Bulletin #10 we explained how ATR is calculated and gave an overview of its many uses and benefits. In Bulletin #12 we showed some specific examples of how using ATR can help to make our systems more robust. In Bulletin #13 we showed some of our favorite applications of ATR as part of our entry logic.

In this Bulletin we will show how ATR can help us achieve more accurateexits.

ATR EXIT TARGETS: Perhaps the most valuable of all application of ATR is to use it to define profit objectives. If we were to run some tests to define profit objective in terms of dollars we could probably find a particular dollar amount that produced acceptable results when reviewing historical data. Just as an example, let's assume that we run some optimizations to find the best level at which to take profits in a particular market and we find that the best number is $1250. Although this amount may produce acceptable results on a historical basis it is not always the best solution to the problem.

When the market is quiet and there is little volatility our profits are likely to fall well short of our $1250 objective. However when the market is volatile and trending strongly our potential profit might be much greater than $1250. The $1250 level is simply a not so happy medium that is usually either too large a target or too small a target.

On the other hand if we measure our profit objective in terms of ATR we have a much more robust and logical solution. Lets assume that we run our tests again looking for units of ATR instead of dollars. Assume our research shows us that our best profit objective is now expressed as 4 ATRs. In a normal market 4 ATRs might be equal to $1250, the same as our dollar denominated target. However in a quiet market 4 ATRS might only be $800. The advantage of our ATR research is that while our original $1250 target is no longer obtainable because of the quiet market conditions the ATR target has adapted to the change in volatility and can still be achieved.

Increases in volatility produce an even more dramatic effect. Let's assume that the market is suddenly streaking in one direction because of some important news. Our 4 ATRs is now $5,000. Wouldn’t it be a shame if our system was taking profits of $1250 when the market is willing to give us $5,000 or more.

In addition to setting profit objectives, ATR can also be very helpful in placing trailing stops. Here are two examples that you may recall from discussions on the FORUM page and past BULLETINS.

THE CHANDELIER EXIT: We have often advocated the importance of good exits and this is one of our favorites. The exit stop is placed at a multiple of average true ranges from the highest high or highest close since the entry of the trade. As the highs get higher the stop moves up but it never moves downward.

Examples:

Exit at the highest high since entry minus 3 ATR on a stop.

Exit at the highest close since entry minus 2.5 ATR on a stop.

Application: We like the Chandelier Exit as one of our exits for trend following systems. (The name is derived from the fact that the exit is hung downward from the ceiling of a market.)

This exit is extremely effective at letting profits run in the direction of a trend while still offering some protection against a major reversal in trend. In fact our research has shown that this exit is so effective that you can enter futures markets at random and if you use this exit the results over time will be profitable. (If you don't believe us just try it.) When used for long term trend following the best values for the ATR in most markets ranges somewhere between 2.5 and 4.0.

THE YO YO EXIT: This exit is very similar to the Chandelier Exit except that the ATR stop is always pegged to the most recent close instead of the highest high. Since the closes move higher and lower, the stop also moves up and down (hence the Yo Yo name). Although this stop appears similar to the Chandelier Exit the logic is quite a bit different. The Yo Yo Exit is a classic volatility stop that is intended to recognize an abnormal adverse price fluctuation that occurs in one day. This abnormal volatility is often the result of a news event or some important technical reversal that is likely to signal the end of a trend. This logic makes the YO YO exit very effective and we seldom regret being stopped out whenever this exit is triggered.

We should caution you that the Yo Yo stop should never be our only loss protection because if the price moves slowly against our position the Yo Yo stop also moves away each day and, in theory, the stop may never be hit.

Combining the exits: The Yo Yo and the Chandelier exits work best when used together. The Chandelier Exit is typically set at 3 ATRs or more from a high point and never lowered; therefore it will protect us against any gradual reversal of trend. The Yo Yo exit is typically set at only 1.5 to 2.0 ATRs from the most recent close and will protect our position from unusual one day spikes in volatility. When used together the operative stop each day would be whichever of the two stops is closest.

Money Management Advice: When using any stops based on multiples of ATR we should keep in mind that volatility can quickly expand to where our risk is greater than we intended. We do not want to unknowingly exceed the risk limitations dictated by our money management scheme so we should also have a "worst case" dollar based stop available or be prepared to reduce our position size quickly as the ATR values expand. When should we reduce our position size and when should we implement our fixed dollar stop?

If we are on the right side of the volatility expansion it may not be wise to reduce our position size just as the trade is beginning to do what we hoped for. For this reason I prefer to implement the dollar based stop on profitable positions rather than reducing the size of winning positions prematurely. We obviously want to have big positions in our winners and small positions in our losers. Therefore it would make sense to reduce our position size only if the volatility is increasing in a trade that is going against us. Once extremely large profits have been achieved, positions can safely be reduced without sacrificing too much in the way of potential profits.

By now we hope you have begun to appreciate the value of ATR in designing systems. There are still more uses for ATR that we have yet to discuss (Keltner Bands for example). We hope to have additional articles about ATR sometime in the future. In the meantime we hope this series of articles has stimulated some creative thinking about the many uses of ATR. Lets us know if you come up with more creative ideas on how to apply this wonderful technical tool.

Drawdown is a topic that is seldom discussed in depth because everyone assumes that its meaning is obvious and that they understand how it should be used in evaluating or capitalizing a trading system. Of all the statistics used in evaluating a trading system's performance I have found that Drawdown, however it might be defined, is a very unreliable statistic at best.

First lets look at how Drawdown is commonly calculated and expressed. This varies widely throughout the industry and even varies within Omega products. For example in TradeStation and SuperCharts, MaxDrawdown is calculated from a position's entry point and not from a position's peak. If we start a trade, which at some point achieves an open profit of $1,000, and then later close it out at a loss of $500, TradeStation and SuperCharts will record a Drawdown of only $500. However, Omega's Portfolio Maximizer would look at the same data and record a Drawdown of $1,500 which is more in line with general industry practice and is the method by which the CFTC and NFA require Commodity Trading Advisors and Pool Operators to calculate Drawdown.

At first glance one might assume that the CFTC/NFA calculation is fairer, or at least more conservative, but that isn't necessarily the case because the regulators require that drawdown be expressed in percentage numbers rather than in dollars. Ask a CTA for their maximum drawdown and you will receive an answer like "35%" not XXX dollars. This makes the size of the drawdown as much dependent on the size of the account at its peak as it is on the size of the decline in equity. A $10,000 drawdown from an equity peak of $100,000 is 10% and the same $10,000 drawdown from an equity peak of $200,000 would be only 5%. Using this formula it would also mean that a trader who never had a loss would still report a drawdown because the giveback of open profits is included as "Drawdown". Omega's Portfolio Maximizer uses this method to calculate Drawdown and it differs substantially from the way that TradeStation and SuperCharts calculate Drawdown.

Even if we assume that we understand which specific Drawdown calculation we are looking at and know how it was calculated, the meaning and application of this statistic are still very suspect. Let's use the trade by trade report of three systems as an example.

System "A" begins trading and has the following closed out trades (we only need a very small sample to illustrate our point):

Loss of $500
Loss of $250
Gain of $2,000
Loss of $500
Gain of $2,500
Gain of $1,000

Using the TradeStation formula this system would have a MaxDrawdown of $750. Keep in mind that if the first trade started out as a $1500 open profit at some point before it was closed out at a $500 loss, the Portfolio Maximizer formula would have recorded the drawdown on this trade as $2,000 not $500. However, lets keep our examples as simple as possible and record the MaxDrawdown for system "A" as $750 (the results of the first two losses, $500 plus $250) as it would show in TradeStation.

Now lets look at the trades for system "B":

Loss of $500
Gain of $2,000
Gain of $2,500
Loss of $500
Gain of $1,000
Loss of $250

Using the TradeStation formula this system would have a MaxDrawdown of $500.

As our final example, lets look at system "C":

Gain of $1,000
Gain of $2,500
Gain of $2,000
Loss of $500
Loss of $500
Loss of $250

Using the TradeStation formula this system would have a MaxDrawdown of $1250.

All three systems made $4,250 and had 50% winning trades. The size of the average winners and losers was identical, as was the Profit Factor (Gross Profits of $5500 divided by Gross Losses of $1250). However, the MaxDrawdown, Account Size Required and Return on Account would all vary substantially.

Which system is best? Which system has the best risk to reward ratio? How should each system be capitalized? Which system is most likely to have the smallest drawdown in the future? In our opinion A, B, and C are all the same system and there is no way to differentiate between them.

Our sample of trades is purposely small but it wouldn't matter much if it were 300 trades instead of only six. In our opinion the sequence of trades in the future will be random and the only valid way to estimate possible drawdowns would be to scramble a large sample of trades and redistribute them randomly. The result might then be expressed as something like this: "Based on a starting capital of $100,000 there is a 28% probability of a drawdown of 50% given 10,000 trials." This drawdown study would require a program that would accept the trade by trade output and then perform a "Monte Carlo" simulation that would redistribute the trades in a different sequence over many trials. Even then our real time experience with drawdowns will be impossible to quantify with any accuracy. The best we can do is to find a range of probabilities and hope that our actual experience falls somewhere within that range.

We know of at least one program that was developed to do this type of drawdown simulation. It is not currently offered for sale but if we can persuade the developer to offer it to our members at a reasonable price we will make it available. There may be other programs that can do this simulation as part of a bigger package but they are generally quite a bit more expensive than the specific software we have in mind.

When building our trading systems we assume that our members would prefer systems that have relatively small historical drawdowns. However we believe that the percentage of winning trades and the size of the winners vs. losers are a much better indication of what to expect in the future than the historical Drawdown statistics viewed out of context. This is one of the reasons you will find that our systems generally emphasize a high winning percentage. In our experience a high winning percentage is the factor that most helps us to control drawdowns.

To summarize, we can not afford to ignore data related to Drawdowns, but we must be very careful how much we rely on this information. As we have attempted to illustrate in this Bulletin, historical Drawdown data tells us very little about what to expect in the future. We suggest that when you look at this data you consider it for the limited value it might have; but don't ever count on it. Of all the performance data we might review, Drawdown and the data calculated from it (Account Size and Return on Account) appear to be the least reliable.

Indicators Are Not Systems

In addition to participating in the discussions on our own FORUM page, we spend a great deal of time monitoring various newsgroups and web sites that deal with trading and technical analysis. One of the popular topics of course is the relative value of various technical indicators. For example someone might ask: "Which is better, MACD or Bollinger Bands?" Or simply: "Which is more profitable: ADX or CCI?"

The implication of these questions is that indicators are being confused with trading systems. We think it is important to understand that technical indicators are best thought of as being merely small parts of a system and not systems in and of themselves. A typical comment like: "I tried Indicator X and found it was worthless." makes no sense at all. Or, "I tried ADX and found that it was excellent." These statements imply that an indicator was tested as though it were a system.

In our eyes there are no good or bad indicators. Indicators are best thought of as tools for solving specific trading related problems. One indicator may be an excellent way to solve one particular problem and the same indicator can be of no value in solving a different problem. The value of any indicator depends on its application. As system developers we must avoid sweeping judgmental evaluations that might conclude that indicator A is better than indicator B. Our task is to learn which indicators can best solve particular problems and make certain that we apply whatever indicator is appropriate for the task at hand.

Every indicator has its strengths and weaknesses depending on how it is applied. For example we have found that moving averages are poor entry triggers but excellent directional indicators. The fact that the five-day moving average is above the twenty day moving average may be a reliable indication that the trend is up but it doesn't mean that we want to buy immediately. On the other hand an upward range expansion might be an excellent entry trigger but have no value in telling us the direction of the underlying trend. If we combine these indicators so that we go long in a market where the five-day moving average is above the twenty-day moving average immediately upon an upward range expansion, then we are getting into the construction of a viable system. However if we bought or sold every range expansion or 5/20 moving average crossover we would quickly conclude that these indicators had no value.

David Lucas and I are presently working on a second edition of our book, Computer Analysis of the Futures Market. Perhaps our original book contributed to some of the misunderstanding about indicators. As you may recall, in our first edition we tested many popular technical indicators as entry triggers and concluded that almost all of them were useless for this task. At that time most technicians approached technical indicators as though the only purpose for an indicator was to be a stand-alone entry trigger. After many years of continuous analysis and research we have learned that indicators have many different applications and that they should not be judged or compared solely on their value as entry timing techniques.

We have learned that indicators should be viewed as tools and not systems but we also need to understand something basic about using tools. If we tried to hammer a nail with a saw we might discard the saw as a useless tool. If we tried to cut a board with a hammer we might conclude that a hammer was a useless tool. Once this is understood our task is to learn which trading tools can be used to solve which trading problems and quit trying to find, buy or invent the best possible indicator. The "best" indicator is simply the one that solves the immediate trading problem at hand and that problem rarely requires another entry trigger. Instead of looking at indicators as entry triggers we must give more thought to using indicators as setups that define market conditions prior to entry and to using indicators that can help us improve our exits. In our opinion the world of technical analysis already has more indicators than we know how to use and the recent proliferation of indicators without a purpose merely add to the confusion. I would suggest that anyone planning to introduce a new indicator should clearly state its intended purpose and application and show some test results that indicate is possible effectiveness at the assigned task.

In terms of need and practical value I would most like to see an indicator that would help in selecting which markets are most likely to trend strongly in the next few months. I suspect that there might be some merit in an indicator that measures and incorporates both volatility and directional movement. If there are any mathematicians among our members that would like to have a crack at developing such an indicator please keep me advised of your progress.

In the weeks to come we will try to share some insight on which indicators we think work best on specific problems that we typically encounter when building a trading system. Our knowledgeable members can also help. If you have found any indicators that work well on particular problems please share some of your knowledge with us privately by e-mail or publicly on our Forum page. Here are just a fewexamples of what would be helpful: We are looking for setups that indicate sideways markets. We are looking for setups that are predictive of increasing volatility. We are looking for exit setups that tell us when to tighten our exit stops. We are looking for an indicator that might be helpful on telling us how soon to implement a break-even stop. We are looking for short-term patterns that are good entry or exit triggers.

Or perhaps you have isolated a problem that we have failed to mention and have an indicator that solves that problem. In a nutshell, what we are looking for is a matching of indicators with the problems that they can solve. We don't want to hear that the X indicator is a great indicator or that the X Indicator is better than the Y Indicator. Let's start sharing information about indicators on a very task specific basis and we will all become better traders.

Identifying Market Conditions

We have been having some very interesting discussions on our Forum. One of the threads that I have found to be particularly interesting recently is on the subject of
Curve Fitting/ Over-optimization at http://traderclub.com/cgi-bin/discus/show.cgi?18/45

I was about to post a response to one of the many excellent messages in this thread when I decided that this rather lengthy response might make an interesting Bulletin.

- - - - - - - - - - -
Snip from message from Kevin Morgan on 6/27/99 - Kevin stated:

"My conclusion is simple. We need to focus on two things:

1. A typography of market conditions.
2. Effective trading methods for each. "

- - - - - - - -

An excellent post, Kevin. Thanks. I agree. Lets tackle first things first. Let’s try and work out a concise breakdown of market conditions and once we have done that we can try to find ways to identify and then trade each condition.

I would propose that market conditions can be defined using three elements: direction and slope are the two I am most positive about. The third possibility is either volatility or orderliness, or perhaps both. I would like to have some help on this from our members so feel free to jump in and agree or disagree and contribute any ideas. Consider my ideas as just a place to start.

Direction = up, down or sideways. I think it is important to think of sideways as a direction when describing market direction. Here is a sample of how this logic might appear:

Upward Direction
A. Upward with low slope (Direction is up but slope is low. The market is moving up gradually.)
B. Upward with high slope (Direction is up and slope is steep. The market is moving up rapidly.)

Now I believe that we might want to add another factor that would further define the conditions. That factor would relate to the size of the short-term deviations from the general slope.

Lets assume that we are moving upward so that a trend line under the lows points upward at about a twenty degree angle. If we now draw an approximately parallel line along the highs, the trendline along the highs could be close to the trendline of the lows or it could be far away. The space between the trendlines could be referred to as the amount of short-term volatility or disorderliness. If the lines are close together we will describe the slope as “orderly” and if the lines are far apart we will describe the slope as “disorderly”.

I doubt if I would actually want to use trendlines to measure or identify these conditions but it helps in visualizing what I want to describe. As you can easily tell, I’m not a mathematician. I’m simply trying to paint a verbal picture that we can use to describe various market conditions. Our outline of market conditions would now look like this:

Upward Direction
A. Upward with low slope (Direction is up and the market is moving gradually.)
1. Orderly (We will call this “Condition 1”. )
2. Disorderly (We will call this “Condition 2”)

B. Upward with high slope (Direction is up and the market is moving rapidly.)
1. Orderly (We will call this “Condition 3”)
2. Disorderly (We will call this “Condition 4”)

Sideways Direction (No slope to measure. Our trendlines are both moving sideways.)
A. Orderly (We will call this “Condition 5”)
B. Disorderly (We will call this “Condition 6”)

Downward Direction
A. Downward with low slope (Direction is down and the market is moving gradually.)
1. Orderly (We will call this “Condition 7”)
2. Disorderly (We will call this “Condition 8”)

B. Downward with high slope (Direction is down and the market is moving down rapidly.)
1. Orderly (We will call this “Condition 9”)
2. Disorderly (We will call this “Condition 10”)

There you have it. We have identified ten different market “conditions” that will have major impact on the results of various trading systems. (Actually I am going to add an eleventh condition called “Unknown” or “None of the above.”) Next we need to figure out how to identify each of these conditions systematically and incorporate that analysis into our trading systems. Send us your ideas and suggestions for code and indicators that would identify each condition. Here is a review of the eleven conditions:

Condition 1 = Market is moving upward gradually in a narrow channel.
Condition 2 = Market is moving upward gradually in a wide channel.
Condition 3 = Market is moving upward sharply in a narrow channel.
Condition 4 = Market is moving upward sharply in a wide channel.
Condition 5 = Market is moving sideways in a narrow channel.
Condition 6 = Market is moving sideways in a wide channel.
Condition 7 = Market is moving downward gradually in a narrow channel.
Condition 8 = Market is moving downward gradually in a wide channel.
Condition 9 = Market is moving downward sharply in a narrow channel.
Condition 10 = Market is moving downward sharply in a wide channel.
Condition 11 = Unknown or none of the above.

Part one: Importance of Exits

The outcome of every trade is dependent on the exit. If we enter in a timely fashion and then exit poorly, the trade is likely to be a loss. If our entry happens to be poor but our exit is good we might still salvage a profit. The exits, not the entries, determine the outcome of our trades. This lesson about exits is easily demonstrated. Take any entry strategy and begin combining it with different exit strategies. You will quickly see that we can change the results dramatically by making only minor adjustments to the exits. In fact it becomes nearly impossible to tell if an entry is any good because the results are so exit dependent. Bad exits can make a good entry look bad and good exits can make a bad entry look good.

When testing the validity of an entry method it is best to begin by simply exiting the trades after a number of bars. If you do anything more creative than this simple exit you will find that you are really testing your exits, not your entries. If you change the exits while attempting to test an entry strategy the results will vary so much depending on the exits selected that you will find that you can not make any valid assumptions about the reliability of the entry. When combined with the right exit the entry strategy looks great. When combined with the wrong exit the same entry looks terrible.

The purpose of an entry is to get the trade started in the right direction. To test the effectiveness of an entry we simply measure what percentage of the time it gets our trade started in the right direction. For example if we have entry "A" that has 60% winning trades after five days it is better than an entry "B" that has only 45% winners after five days.

You will notice that we made no comparison of risk or profitability in picking the best entry. What if entry "A" lost money and entry "B" made money? Is entry "A" still better? The answer is "Yes" because the purpose of an entry is merely to get the trade started in the right direction. After that everything else is dependent on the exits. Entry "B" just happened to make more money because of the particular exit we selected for the test. We can easily adjust our exits and we will find that entry "A" will consistently make more money than entry "B" because it gets the trades started in the right direction more often. To maximize our profit we need to combine the right entry with the right exit.

In our book, Computer Analysis of the Futures Market, we tell an amusing anecdote about a trader who seemed a bit loony because he used a Coke bottle with a broken radio antennae sticking out of it to receive trading advice from other planets. This advice, like most trading advice, was only related to the entries. When the voice from the Coke bottle told him to enter a trade he would come back to my desk and want to put the trade on right away saying something like: "They are buying soy beans on Mars, buy some beans for me".

The other traders sitting around the board room would overhear these frantic orders and became quite interested in this strange trading advice. Naturally they were quick to make fun of the trader when he was losing but they didn't have much to say when he was winning. The trader with the Coke bottle eventually learned that to avoid ridicule he had to take his losses quickly and hold on to his winners as long as possible. His trading steadily improved and he wound up being a surprisingly good trader. Obviously, his reliance on trading advice from other planets had nothing to do with his success. His entries were no better or worse than random but he had learned to be very good at his exits.

Second in a Series of Articles About Exits

Part Two: The Money Management Exit

In Bulletin #29 we emphasized the importance of exits in general and pointed out that it is the exits and not the entries which actually determine the outcome of our trades. Now that we have established the importance of exits we will be more specific and write about various types of exits. Probably the simplest and most critical exit is the money management exit or the classic "stop loss". This is the exit that protects our trading capital and prevents ruin.

To trade futures and other leveraged investments without a money management stop is certain ruin. Well-known trader and author Victor Niederhoffer lost tens of millions of dollars of his client's money when he traded his fund down to zero and some twenty-million beyond. No surprise there. The inevitable outcome of an investment with this ill-fated trader was clearly determined years ago when Niederhoffer wrote:

"I have never used stops, even to bail myself out. Somehow, having a fixed rule to exit provides my adversaries too great an advantage. " - Victor Niederhoffer, from "The Education of a Speculator", page 376

Niederhoffer's demise was no surprise to industry professionals. The only speculation was on how long it would take for him to go bust. To his credit, he lasted longer than was generally expected. Niederhoffer's paranoia about money management stops is not uncommon among naive beginners but it is an attitude that is rarely seen among seasoned professionals. The first priority in trading must always be to preserve our trading capital from the risk of catastrophic ruin. Everything else becomes secondary to this objective.

Note carefully how we have stated this goal. We did not say that our goal was to eliminate or reduce the risk of loss. Reasonable losses are an integral part of the trading process. Good traders accept losses as a cost of doing business. In fact I have observed that good traders probably take more losses than bad traders do. The critical issue in this discussion is the size of the losses that are acceptable. Catastrophic losses must be avoided at all costs and these losses are easily avoided by always employing a simple money management stop.

Niederhoffer mistakenly assumed that he was such a good trader that he could violate the cardinal rule of trading and not use money management stops. The truth is that good traders actually need money management stops more than bad traders do. Bad traders are going to fail very quickly whether they use money management stops or not while good traders will survive and prosper indefinitely. The better and longer you trade the more likely that you will eventually encounter a potentially catastrophic event.

The money management stop commits a trader to a pre-defined loss point that a trader can accept and the stop will allow him to exit a losing trade unemotionally. The trader who uses a money management stop knows from the outset that he can only give the trade a limited amount of room to move against him, and after that, he will cut his losses by exiting the trade according to his plan. This is a tremendous psychological advantage. Having a fixed point to exit a trade with a loss removes a great deal of stress in dealing with any losing position. The trader with his stop in place always knows exactly when he has to exit and avoids the pain of having to watch the loss grow larger and larger day after day.

This psychological advantage of money management stops also helps the trader before he takes a trade. Suppose the system called for us to take a trade in a specific market tomorrow, and we had an unknown and unlimited potential for loss. No knowledgeable trader would be willing to take such a trade. However, if you have a money management stop and know exactly what the worst loss could be beforehand, it is psychologically much easier to pull the trigger and confidently enter that trade. We already know and are prepared for the worse case scenario and we have determined that the amount of risk is acceptable to us. Money management stops give the trader the benefit of a worst loss estimate on any trade. This knowledge gives us the confidence to enter the trade and the psychological preparation to accept the loss should it occur. Of course money management stops may not always predict the exact amount of the worst loss, since markets can sometimes gap against the position and cause a much larger loss than planned. However in most cases the money management stop is a reasonable indication of the worst loss likely in a trade.

Over the course of this series of articles about exits we will describe a few of the basic money management stops that all traders should be familiar with. We will describe the basic Dollar Stop in this Bulletin and describe other recommended Money Management stops in subsequent bulletins.

The Dollar Stop: The simplest money management stop is a stop that is positioned a fixed dollar amount away from the entry price of a trade. Dollar stops are easy to implement and most trading software allow for easy incorporation of dollar stops into any trading system. Simple as this may sound, there are incorrect and correct ways to use a dollar stop in your systems.

The incorrect way to use dollar stops is to figure the maximum amount you can afford to lose in the trade, and then set the dollar stop accordingly. Unfortunately, the market does not make adverse price movements based on how much money you can afford to lose.

The correct way to set dollar stops is to use market characteristics and system testing statistics to determine its placement. For instance, dollar stops should not be placed too close to the markets because random price movement will cause the trade to be stopped out prematurely. Neither should dollar stops be placed too far away from the market, since that means you are willing to take a much larger loss than is necessary. In our experience, dollar stops should be placed based on some volatility measure of the market. For instance, if the average daily range of a market is $1,000, it is recommended that the dollar stop on that market should be at least $1,000 if not more. This amount should keep the stop out of the random price movements while maintaining its function of capital preservation. Again, it must be stressed that adequate system testing and analysis must precede the implementation of any dollar stop to ensure proper performance.

It is important to understand the volatility characteristics of the market you are trading and not to blindly use a fixed dollar stop for all markets, nor even for a single market if that market has changing volatility characteristics. The challenge then is to develop money management stops that are adaptive to current market volatility conditions.

In our next Bulletin we will discuss the use of Adaptive Money Management stops.

Third in a Series of Articles about Exits

Exits - Preparing for Dangerous Reports and "Price Shocks"

Although we were scheduled to continue our series on exit strategies with a Bulletin about adaptive money management stops, I wanted to interject this Bulletin with a brief bit of advice about handling important reports and potential "price shocks" when trading. This topic was brought sharply to mind only last Friday when the monthly employment report caused the bonds to rally more than a full point in just a few minutes. I thought it would be best to write this Bulletin while the subject was still fresh on my mind.

On Thursday's close we were short the September bonds in the Sidewinder Bond system and we told our Signals Service subscribers to exit the short position on the opening Friday and avoid going through the report. This advice proved to be quite timely because the bond market rallied well over a point from the opening once the employment report was released. We received some thanks for the timely advice and many hearty congratulations for correctly forecasting the direction of the report which most bond market observers anticipated would be bearish. The truth is that we made the correct decision without any forecasting. I thought that an explanation of the logic that lead to this timely profit-saving decision would be a valuable lesson to our members who are concerned about trading during reports. Here is our general philosophy about handling reports and news events that may impact our positions. We think it is sound and practical advice learned from more than thirty-five years of futures trading experience.

If we are holding a position in a long-term trend-following system we will usually ignore reports unless they are expected to be of such impact that our protective stops will become useless in their critical role of preserving our trading capital. The most dangerous reports are usually those that are issued while the markets are closed and result in overnight price gaps that leap over our protective stops and cause losses much greater than we are prepared for. If a dangerous gap-creating report such as we have just described is scheduled, we will exit our position prior to the report and then perhaps re-enter the trade after the report data and its impact on the market is known. The logic of this exit strategy is simple. We are always willing to forego windfall profits in order to avoid catastrophic losses. In the long run the probabilities are that half of these dangerous reports would go in our favor and the other half would go against us. This might lead us to assume that an exit procedure for reports will have no impact on our trading but this would be a very mistaken conclusion. Since the outcome of these reports is a 50-50 proposition, by making it a policy to sidestep the danger we do nothing to reduce our profitability but we manage to dramatically reduce our risk. The advantages of avoiding potential gap-making reports is very obvious. We are greatly reducing our exposure to catastrophic risk without any reduction in our profit potential. I wish all trading decisions were as simple as this.

Last Friday's employment report was not of the dangerous gap-making, stop-hopping variety and had we not already been in a profit-taking mode in an expiring contract that needed to be liquidated soon we would have held through the report and relied on our system stops to get us out of the trade. However, since our open profits were modest and we needed to liquidate the September position very soon in any case it seemed clear that we had little to gain by gambling on the short term impact of this report. Successful trading is about profiting from our "edge" or the advantage offered by our system. Gambling on the outcome of reports has nothing to do with successful trading.

It is interesting to note that the employment report last Friday was expected to be bearish and the bond market declined sharply on Thursday in anticipation of a bearish Friday morning employment report. However, when a report is expected to be bearish, this bearish sentiment adds substantially to the risk of a bullish report. Because a bearish report is already factored into the market, any bullish report would be a big surprise. This is exactly what happened and we were not suckered into holding our position through a report whose potentially bearish impact had already been factored into the prices by Thursday's decline. The more the outcome of a report appears to be forecast or "in the market" the more dangerous it becomes. If a report is expected to be very bearish and it turns out to be only modestly bearish, the market is likely to rally on the bearish report. If the anticipated bearish report turns out to be neutral the market is likely to rally strongly and if the report is actually bullish the market will rally by leaps and bounds. Its almost a no-win proposition to be holding a short position through a report that is widely expected to be bearish. If the report is indeed bearish as predicted there will be little reaction and many traders who were on the short side will take their profits on the bearish news thereby dampening the impact of the report. The most dangerous reports are almost always the ones where the outcome seems to be well known before the report is issued.

Like most professional traders we keep an eye out for various reports that may have an impact on our positions. In most cases we simply ignore them. However when we are near an entry or an exit point we will carefully analyze the situation and take measures to reduce our risk. If there are major news events pending that might create large overnight price gaps we will move to the side lines. Our "edge" is intended to give us an advantage in normal markets. Trying to forecast major news events and dangerous gap producing reports is for gamblers, not system traders.

Had the employment report on Friday been bearish instead of bullish we would still argue that our decision to exit on the open prior to the report was the correct decision. There was no forecasting or astute market analysis involved. We simply applied tried and true risk-reduction techniques and got lucky (which mysteriously seems to happen 50% of the time).

This is the Fourth Article in a Series of Articles About Exits

Exits - Adaptive Money Management Stops

In order to study and develop money management stops that are adaptive to current market volatility, it is necessary to move away from the standard dollar stops and examine other ways to place the protective stop based on some measure of market volatility.

One starting point is to use the price action itself to determine the stop placement. For instance, the lowest low or highest high of the last X number of days could be used as a money management stop. We call this a Channel Stop. The Channel Stop is very adaptive to current market conditions, since it changes with trendiness and with volatility. The Channel Stop is further away from the market in times of higher volatility and higher trendiness and closer to the market in times of lower volatility and lower trendiness. This stop is also based on strong logic: we already know that a breakout of a significant highest high or lowest low will often signal an important trend reversal. Therefore our stop-loss placed at a highest high or lowest low point provides a valid technical reason to exit a losing trade.

However one possible disadvantage of this stop is that in a strongly trending market, the stop may be placed too far away. Reflecting the strength of the trend the market might have moved a significant distance from its previous highs or lows. On the other hand, during non-trending periods, the stop may be placed much closer to the markets. As you can see, the actual dollar value of the stop would vary considerably depending on where prices have moved from their last high or low point. This variation might make dollar estimates of the risk per trade difficult to predict until it is actually time to enter the market.

Another adaptive strategy would be to use significant support and resistance levels to define the money management stop position. One could use a significant pattern in the market, such as a pivot low or pivot high, as the position for a money management stop. The advantage of using price and technical points to determine the position of the money management stop is that the stop is placed in a logical position, where adverse price movement exceeding the stop would constitute a logical reason for terminating the trade.

Another way of adjusting money management stops is to use a measure of the current market volatility. We could use the Average True Range over a period of time or the Standard Deviation of prices over a period of time and multiply that by a factor to determine how far away the stop should be placed from our entry price. One of our favorite stops is to simply take the Average True Range over a number of days and to multiply that by a factor and place the stop at that distance from the entry point of a trade. To avoid random price movement, it would be recommended to place the stop more than one Average True Range from the entry price. The advantage of using a stop determined by Average True Range is that it is highly adaptive to current market conditions. The distance from our entry point to the stop would increase in periods of high market volatility, and decrease in periods of lower volatility. In actual practice we have found that most problems with the ATR stop tend to arise when the short term average true range becomes unusually small and our tight stops cause us to be whipsawed. To avoid these dreaded whipsaws we calculate both a short term ATR (3 or 4 days) and a longer term ATR (15 or 20 days) and we always set our stops using whichever of the two ATRs is the largest. This allows the stops to move away quickly but prevents them from moving in too close after a few unusually quiet days. (See Bulletin #14 for a discussion of ATR exits. See Bulletin #10 for instructions on how to calculate ATR.)

Another version of an adaptive money management stop would be to use the Standard Deviation of the past prices as the measure of price volatility. For example, the standard deviation of a past number of closing prices may be calculated, multiplied by a factor, and the money management stop could be placed at this distance away from the entry price. The rationale of this stop is similar to the Average True Range stop. The goal is to place the stop out of the reach of random price movements yet cut our losses when prices move away from our entry by a significant amount.

Adaptive stops that change with market volatility have a significant role in money management. The dollar amount of the potential loss can quickly be calculated before we enter the trade and we can be confident that the size of the potential loss is appropriate for the current market conditions. As an example, suppose our system calls for the placement of a stop at 1.5 times the 20-day Average True Range from our entry point. If we were trading the S&P 500 market back in 1990 where one Average True Range was only $1,250 in dollar terms we would have been placing our stops $1,875 away from the entry point. Now suppose we had an account of $100,000, and we were willing to risk 10% of our capital on each trade. Based on the volatility in 1990 we would have been trading 5 contracts, thereby risking $9,375 of our capital. Now suppose we are in 1999 trading the same system, and one Average True Range in the market is $5,600. This would call for a stop of $8,400. If we were still trading the same $100,000 account with a 10% risk tolerance, we could now trade only 1 contract. As you can see, the adaptive money management stop is an excellent guide to managing risk during periods of changing market volatility.

In our next article about exits we will discuss various types of trailing exits.

Exits - Are Your Money Management Stops Too Large or Too Small?

by Chuck LeBeau and Terence Tan

It seems that Money Management stops are either too close and subject to frequent whipsaws or too far away and expose our capital to large losses. >From the results of our testing, we have concluded that most systems would benefit from the inclusion of relatively large money management stops.

At first thought it would seem that the closer the stops and the smaller the losses, the lower the expected drawdown. However, this seemingly logical assumption does not hold up in testing. In almost all cases the wider stops result in a higher winning percentage and a lower drawdown. Smaller stops appear to be psychologically attractive, but may actually deteriorate system performance because they are susceptible to frequent "whipsaws" caused by random and insignificant price movements. On the other hand, large stops may also be psychologically attractive because they are activated less frequently, and systems with large stops generally tend to have a higher percentage of winning trades. However, the down side is that large stops force the trader to occasionally suffer rather large losses which, although infrequent, can be psychologically difficult to accept as well. Is there a compromise solution to this problem?

We believe there is. An interesting phenomenon we have observed from our research is that it is often possible to tighten the money management stop a short period after the initial trade entry. It has been our preference to allow the trade some latitude to work out in the beginning and this is best accomplished with a relatively large money management stop during the first few days of the trade. However, after a specific number of days the money management stop can often be reduced to a much smaller amount. For instance, if we have a $5,000 stop upon entering a trade on the S&P 500 futures market, and this is an uncomfortably large loss to take, it may be possible to leave the $5,000 stop in place only for the first few days, and then tighten the stop to $2,500 for the remainder of the trade. The chances of being stopped out late in the trade with a $5,000 loss have been reduced, although it is always possible that a large adverse price movement in the first few days could still stop us out with the maximum loss. The exact stop amounts and the time of implementation would have to be determined by computer and statistical analysis of the system's characteristics. In some trend-following systems, we have found that we can benefit substantially by implementing a larger stop in the beginning of a trade, and then reducing the original stop by 50% or more once the trade is underway.

This technique of tightening stops after a few days in the trade has a sound basis: we know that the predictiveness of a trade entry indicator declines as the trade moves out into the future. In most cases an entry indicator has a better chance of predicting the price movement in the next 2 days than in the next 2 weeks. Starting off a trade with a large money management stop allows the trade sufficient room to work in the right direction, since it corresponds to a period of high confidence in the entry indication. As the trade moves out into the future, the confidence of the entry indication declines, so we tighten up the stop to reflect decreasing confidence in the trade.

Other possibilities for dealing with the problem of large stops also exist. Stops such as breakeven stops or profit protection stops that over-ride the money management stop can easily be implemented in later stages of the trade. Once these stops are activated, the possibility of taking the large original stop loss is substantially reduced or eliminated. These and other techniques will be fully discussed in subsequent chapters.

Conclusion

Proper understanding and implementation of the money management stop is vital to a trader's survival. The stop effectively limits the maximum loss that may be sustained in a trade, which in turn contributes to the all-important goal of preservation of capital. Trading without a money management stop is to allow for a high chance of catastrophic loss in your account.

The importance of the Money Management stop is aptly summed up by Jack Schwager with this statement from his book, The New Market Wizards: "If you can't take a small loss, sooner or later you will take the mother of all losses."

Trailing Stops

By Chuck LeBeau and Terence Tan

Now that we have taken the necessary precautions to avoid catastrophic losses by using disciplined money management stops, it is appropriate to concentrate on strategies that are designed to accumulate and retain profits in the market. When properly implemented these strategies are intended to accomplish two important goals in trade management: they should allow profits to run, while at the same time they should protect open trade profits.

While their application is extremely wide, we do not believe that trailing stops are appropriate in all trading circumstances. Most of the trailing exits we will describe are specifically designed to allow profits to run indefinitely. Therefore they are best used with trend following type systems. In counter-trend trading, more aggressive exits are more suitable. The “when you’ve got a profit, take it” philosophy works best when you are trading counter-trend, since the anticipated amount of profits is limited. However, to take quick profits in a trend is usually an exercise in frustration: we exit the market with a small profit only to watch the huge trend continue to move in our direction for days or months after our untimely exit. We therefore recommend using different exit strategies based on the underlying market condition. We will discuss the more aggressive exits later; for now we will concentrate on exits designed to accumulate large profits over time.

A thorough understanding of trailing stops is critical for trend-following traders. This is because trend following is typically associated with a lower percentage of profitable trades; which makes it particularly important to capture as much profit as possible when those large but infrequent trends occur. Typical trend followers make most of their profits by capturing only a few infrequent but very large trends, while managing to cut losses effectively during the more frequent sideways markets.

The rationale behind the use of the trailing stop is based on the anticipation of occasional extremely large trends and the possibilities of capturing substantial profits during these major trends. If the entry is timely and the market continues to trend in the direction of the trade, trailing stops are an excellent exit strategy that can enable us to capture a significant portion of that trend.

The trailing stops we will describe in this and following articles have similar characteristics that are important to understand as we use them to design our trading systems. Effective trailing stops can significantly increase the net profits gained in a trend-following system by allowing us to maximize and capture large profitable trades. The ratio of the average winning trade to the average losing trade is usually improved substantially by the use of trailing stops. However there are some negative characteristics of these stops. The number of profitable trades is sometimes reduced since these stops may allow modestly profitable trades to turn into losers. Also, occasional large retracements in open trade profits can make the use of these stops quite difficult psychologically. No trader enjoys seeing large profits reduced to small profits or watching profitable trades become unprofitable.
The Channel Exit

The simplest process for following a trend is to establish a stop that continuously moves in the direction of the trend using recent highest high or lowest low prices. For example, to follow prices in an uptrend, a stop may be placed at the lowest low of the last few bars; for a downtrend, the stop is placed at the highest high of the last few bars. The number of bars used to calculate the highest high or lowest low price depends on the room we wish to give the trade. The more bars back we use to set the stop, the more room we give the trade and consequently the larger the retracement of profits before the stop is triggered. Using a very recent high or low point enables us to take a quick exit on the trade.

This type of trailing stop is commonly referred to as a “Channel Exit”. The “channel” name comes from the appearance of a channel formed from using the highest high of X bars and the lowest low of X bars for short and long exits respectively. The name also derives from the popular entry strategy that uses these same points to enter trades on breakouts. Since we are focusing on exits and will be using only one boundary of the channel, the term “channel” may be a slight misnomer, but we will continue to refer to these trailing exits by their commonly used name.

For most of our examples we will assume that we are working with daily bars but we could be working with bars of any magnitude depending on the type of system we are designing. A channel exit is extremely versatile and can work equally well with weekly bars or five-minute bars. Also keep in mind that any examples referring to long trades can be equally applicable to short trades.

The implementation of a channel exit is very simple. Suppose we have decided to use a 20-day channel exit for a long trade. For each day in the trade, we would determine the lowest low price of the last 20 days and place our exit stop at that point. Many traders may place their stops a few points nearer or further than the actual low price depending on their preferences. As the prices move in the direction of the trade, the lowest price of the last twenty days continually moves up, thus “trailing” under the trade and serving to protect some of the profits accumulated. It is important to note that the channel stop moves only in the direction of the trade but never reverses direction. When prices fall back through the lowest low price of the last twenty days, the trade is exited using a sell stop order.

The first and obvious question to answer about channel exits is how many bars to use to pick the exit point. For example, should we set our stop at the lowest low of 5 days or the lowest low of 20 days, or some other number of days? The answer depends on the objectives of our system. A clearly stated set of objectives for the system is always very helpful at these important decision points. Do we want a long-term system with slow exits or do we want a short-term system with quicker exits? A longer channel length will usually allow more profits to accumulate over a long run if there are big trends. A shorter channel will usually capture more profits if there are smaller trends. In our research, we have found that long-term systems generally work well with a trailing exit at the lowest low or the highest high of the last 20 days or more. For intermediate term systems, use the lowest or highest price of between 5 to 20 days. For short-term systems, the lowest or highest price of between 1 to 5 days is usually optimal.

Trailing stops with a long-term channel accumulate the largest open profits if there is a sustained trend. However this method will also give back the largest amount of open profits when the stop is eventually triggered. Using a shorter channel can create a closer stop in order to preserve more open trade profits. As can be expected, the closer stop often does not allow profits to accumulate as nicely as the longer channel, and often causes us to be prematurely stopped out of a large trend. However, we have noticed that a very short channel length of between 1 to 3 bars is still highly effective in trailing a profitable trade in a runaway trend. The best type of channel exit to use in a runaway trend is a very short channel, for example 3 bars in length. We have observed that this exit in a strong trend often keeps us in a trade until we are close to the end of the trend.

It appears that there is a conflict of exit objectives here. A longer channel length will capture more profit but give back a large proportion of that profit; a shorter channel length will capture less profit, but protect more of what it has captured. How can we resolve this issue and create an exit that can both accumulate large profits, as well as protect these profits closely? A very effective exit technique calls for a long-term channel to be implemented at the beginning of the trade with the length of the channel gradually shortened as larger profits are accumulated. Once the trade is significantly profitable, or in a strongly trending move, the goal is to have a very short channel that gives back very little of the large open profit.

Here is an example of how this method might be implemented. At the beginning of a long trade, after setting our previously described money management stop to avoid any catastrophic losses, we will trail a stop at the lowest low of the last 20 days. This 20-day channel stop is usually far enough from the trade to avoid needless whipsaws and keep us in the trade long enough to begin accumulating some worthwhile profits. At some pre-determined level of profitability, which can be based on a multiple of the average true-range or some specific dollar amount of open profit, the channel length can be shortened to take us out of the trade at the lowest low of 10 days. If we are fortunate enough to reach another higher level of profitability, like 5 average true ranges of profit or some other large dollar amount, we can shorten the channel further so that we will exit at the lowest low of 5 days. At the highest level of profitability, perhaps a very rare occurrence, we might even be able to place our exit stop at the previous day’s low to protect the great profit we have accumulated. As you can see, this strategy allows plenty of room for profits to accumulate at the beginning of a trade and then tightens up the stops as profits are accumulated. The larger the profits, the tighter our exit stop. The more we have, the less we want to give back.

There is another way of improving the channel exit that is worthwhile to discuss: this is to contract (or expand) the traditional channels using the height of the channel, or some multiple of the average true range. How this might work is as follows: Supposing you are working with a 20-day channel exit. First you calculate the height of the channel, as measured by the distance between the highest 20-day high and the lowest 20-day low. Then you contract the channel by increasing the lowest low value and decreasing the highest high value previously obtained to determine the exit points. For instance, in a long trade, you could increase the lowest low price by 5% of the channel height or 5% of the average true range, and use that adjusted price as your exit stop. This creates a slightly tighter stop than the conventional channel. More importantly, it allows you to execute your trade before the multitude of stops that are already placed in the market at the 20-day low.

The last point can be considered an important disadvantage of the channel exit. The channel breakout methods are popular enough to cause a large number of entry and exit stops to be placed at previous lowest low and highest high prices. This can cause a significant amount of slippage when attempting to implement these techniques in your own trading. The method of adjusting the actual lowest low or highest high price by a percentage of the overall channel height or the average true range is one possible way to move your stops away from the stops placed by the general public and thereby achieve better executions on your exits.

Trailing Stops - The Chandelier Exit

By Chuck Le Beau and Terence Tan


In Bulletin #34 we discussed the Channel Exit which trails a stop based on previous LOW points. In this Bulletin we will discuss a stop placement strategy that trails our stop based on previous HIGH points.

The Chandelier Exit hangs a trailing stop from either the highest high of the trade or the highest close of the trade. The distance from the high point to the trailing stop is probably best measured in units of Average True Range. However the distance from the high point could also be measured in dollars or in contract based points.

Here are three simple examples: (As usual we will use long side examples. Simply reverse the logic for short trades.)

1. Place a stop at the highest high since we entered the trade minus three Average True Ranges. 2. Place a stop at the highest high of the trade minus $1500.00. 3. Place a stop at the highest high of the trade minus 150 points.

The value of this trailing stop is that it moves upward very promptly as higher highs are reached. The Chandelier name seems appropriate and should help us to remember the logic of this very effective exit. Just as a chandelier hangs down from the ceiling of a room, the Chandelier Exit hangs down from the high point or the ceiling of our trade.

The reason we prefer to use units of Average True Range to measure the distance from the high to our stop is that the ATR is applicable across markets and is adaptive to changes in volatility. We can use the same formula to trade corn, yen, coffee, or stocks. If the trading ranges expand or contract our stop will automatically adjust and move to the appropriate level continuously staying in tune with changing market conditions. (Members who are not already familiar with the many valuable applications of Average True Range should be sure to review Bulletins #10, 11, 13, and 14.)

In Dr. Van K. Tharp's excellent book, Trade Your Way to Financial Freedom, he refers to a study he conducted to demonstrate that an effective exit strategy could produce profits even with random entries. We were not surprised to see that the exit methodology he used to produce the profitable test results across a diversified portfolio of futures markets was the Chandelier Exit. (Tharp used three ATRs trailing from the highest or lowest close and used a ten-day exponential moving average to calculate the ATR.)


Protecting Open Profits

When we discussed the Channel Exit in Bulletin #34 we suggested that at the beginning of a trade we should use a wide stop and then, as profits are accumulated, tighten the stop by reducing the number of bars in the Channel. The same profit-protection logic can be applied using the Chandelier Exit. At the beginning of a trade the distance to the stop in most futures markets should probably be in the neighborhood of 2.5 to 4 Average True Ranges. As the trade becomes increasingly profitable we can bring the stop closer by reducing the units of ATR from the high to our stop.

Let's assume that we started with 3 ATRs at the beginning of the trade. After we have reached our first profit level we might tighten the stop to trail the high point at only 1.5 ATRs. After the second profit level is reached we might want to tighten the trailing stop to only one ATR. We have had good results with some highly profitable trades by trailing exits as close as a half an ATR. We have found that some markets have better trending characteristics than others and we prefer to adjust the trailing stops on a market by market basis so there is no universal formula that we would recommend. The important message we want to convey is that to capture the maximum profit potential of trend-following trades the trailing stops need to be tightened as significant profits are accumulated.

Keep in mind that although the highs used to hang the Chandelier move only upward the changes in volatility can shorten or lengthen the distance to the actual stop. If you want to see less fluctuation in the stop distance use a longer moving average to calculate ATR. If you want the stop placement to be more adaptive to changing market conditions, use a shorter moving average. We normally use about twenty bars to calculate the ATR unless there is a specific reason to adjust it. In our experience the use of very short averages (3 or 4 bars) for the ATR can often create problems when there are brief periods of small ranges that tend to bring the stops too close. These abnormally close stops may cause us to exit prematurely. If we want to have a short and highly adaptive ATR without risking placing stops that are too close, we can calculate a short average and a longer average (maybe four bars and twenty bars) and use the average that produces the widest stop. This technique allows our stops to move away quickly during periods of high volatility without the risk of being unnecessarily whipsawed during brief periods of low volatility.

Combining the Channel Exit and the Chandelier

We like to start our trades with the trailing Channel Exit and then add the Chandelier Exit after the price has moved away from our entry point so that the open trade is profitable. The Channel Exit is pegged at a low point and does not move up as new profits are reached. The Channel Exit will move up only when enough time has passed that the previous low is dropped from the data period of the channel. The Channel Exit moves up very gradually over time but it does not move up relative to any recent highs that are being made. This is why we need the Chandelier Exit in place to make sure that our exits are never too far away from the high point of the trade.

By combining the two exit techniques we can use the Channel Exit as an appropriate stop that very gradually rises at the beginning of the trade. However if the trade makes a run in our favor the prices will quickly move very far away from our slowly trailing Channel Exit. Once we are profitable we need to have a better exit that protects more of our profit. At this point it would make sense to switch to the Chandelier Exit which will rise instantly whenever new highs are reached. This valuable feature of the Chandelier makes it one of our most logical exits from our profitable trades.

As you can see, the Chandelier Exit is a very useful tool. However coding the Chandelier Exit in TradeStation is not necessarily a straightforward matter. For the convenience of our members we are posting the TradeStation code on our web site at:

http://www.traderclub.com/toolkit.htm#chandelier

Entries - How to Buy on Dips and Sell on Rallies

Those members who have purchased our systems will quickly acknowledge that we have a fondness for trading systems that go long on dips and short on rallies. We have developed at least one system with that strategy in each of the markets we trade. In the S&P market and the Bond market we have developed more than one system that takes this preferred approach.

The benefits of buying into an uptrend on dips and selling into a downtrend on rallies are probably obvious. If we compare the dips and rallies approach to entering on breakouts we can see that the "dips" entry strategy allows us to enter at cheaper prices with less risk and more profit potential. That is a nice combination of benefits. In this Bulletin we will share some of our conclusions from our many hours of research on how to identify these potentially profitable opportunities.

First, the strategy is going to work best if there is a trend. (Lets simplify things by using examples only for the long side. Unless otherwise noted you can assume the procedure for selling short is just the opposite.) Trend identification is a big topic in its own right but for our purposes we don't have to come up with anything fancy. The direction of a moving average or the relationship of two moving averages will work just fine. We could also take a simple momentum approach and require that the close today must be a minimum amount higher than it was X days ago. For example, we might want the close to be more than three ATRs higher than the close twenty days ago. When we were at Dr. Elder's Trader Camp he recommended that stock traders should look for both a rising 22 week moving average and a rising 22 day moving average. That's an excellent suggestion. We have found that the specific method of identifying the direction of the trend is not critical to the success of the system. In fact we have used a different method of measuring the trend in each of our systems. If you already have a favorite definition of trend by all means use that.

Once the direction of the trend is established we need to go to work on defining a "dip". Now here is a valuable tip: The stronger the trend the smaller the dips. This seems obvious once it is pointed out but we see too many traders overlooking this important concept. They typically want to get long in an uptrend when some oscillator like RSI or Stochastics is "oversold". We have found that oscillators only reach oversold levels when the market is weak or trendless. The ideal "dip" entry is a very small dip in a very strong uptrend. These ideal trades have the lowest risk and the highest profit potential.

Fortunately we don't necessarily have to know the exact strength of the trend because we can define a minimum definition of "dip" so that we can catch small dips as well as any bigger dips. This procedure will allow us to catch the ideal trades as well as those highly profitable trades that are less than ideal. The most important point to remember here is that if we demand too great a dip we will be missing some of the best trades.

Here are a just few ideas on how we might define a minimum dip: 1. The close today (or the low today) is 1 ATR or more below the close (or the high) 3 or 4 days (or bars) ago. 2. The RSI has declined 10 points or more from its high 3 or 4 days ago. 3. The low of the last 2 or 3 days has gone below the 7 day moving average. 4. A recent low has penetrated below some moving average of lows. 5. Some oscillator like RSI or Stochastics has gone below a threshold level (like 50 or 60). Remember: We don't expect it to reach oversold levels. 6. The Plus DI (part of the ADX indicator) has declined some amount from its peak. 7. The Minus DI has risen some amount from its low. 8. The slope of a short term moving average has turned down.

I'm sure that with a little thought you could add extensively to this list. It is important to understand that we do not necessarily enter once the dip has reached the minimum level. We think that we can obtain a higher percentage of winning trades by waiting for some entry "trigger" that will signal that the "dip" is over and that the prevailing up trend has resumed. The minimum "dip" is merely a setup condition and we want some indication of strength to actually initiate the trade.

Here are a few possible entry triggers: 1. Place a buy stop at yesterday's high. 2. Place a buy stop at X points or some fraction (0.4?) of ATR above tomorrow's open. 3. Place a buy stop some unit of ATR above the lowest low of the last 3 days. 4. Enter if the close tomorrow is X points above the open. 5. Enter when the close is the highest close of the last 3 days. 6. Enter on a higher close when the daily range has expanded. (Today's True range is greater than the 3 day ATR.) 7. After an inside day enter at the high of two days ago. 8. Enter on a stop at the 3-day moving average of the highs.

There are lots of possibilities but you will notice that in each of these situations we are not trying to buy on the lows. What we want to see is some evidence that the correction is over and that the trend has resumed. This form of trigger along with our reliable identification of the underlying trend will give our trades a very high probability of success. Many skeptics assume that our systems obtain unusually high winning percentages from excessive optimization. We believe the high winning percentages are obtained from the sound logic of making sure that we are headed in the right direction at the very beginning of each trade. If we are making sure that the short, intermediate and long term trends are all going in our favor we should expect to have our trades showing profits right from the start. Whether or not they are profitable when we exit will eventually depend on the quality of our exit strategies.

In addition to the contribution to a high winning percentage our entry triggers also allow us to take advantage of setting our "dip" levels at the minimum. Very often our entry will not be triggered until the dip has gone well below the minimum level. You will notice that we have not tried to forecast the exact low of the dip. We will be happy to initiate the trade at any level once the minimum has been reached.

If you are a day trader reading this Bulletin simply substitute the word "bars" whenever I have referred to "days". Very short term day traders may want to go ahead and enter "at the market" once the minimum threshold has been reached because the system as described will be giving up some potential profits waiting for signs of strength to trigger the entry. When you are trading short term you need to maximize the profits, perhaps at the expense of sacrificing a few points off the winning percentage. Longer-term traders are better off taking the recommended entry triggers and maximizing their profits by using more patient exits.

In a future Bulletin we will present some ideas on how to measure the actual strength of the trend rather than just the direction. Once the strength of the trend is measured then perhaps we can adjust our entries to make them even more accurate. We will also share some of our work on distinguishing between dips and trend reversals. Although we are not yet as proficient at this as we would like to be we have made enough progress to incorporate a filter into the Millennium ED System that helps us to avoid some dips that turned out to be reversals. We would hope to make more progress in this area as our research continues.

* * * * * * Traders Club Survey

Thanks to all those members who took the time to respond to our recent survey. The comments and suggestions have been very helpful and I have been trying to personally respond to each and every member who sent us their comments. (Its going to take me a while so if you sent back the survey and you haven't yet heard from me you should receive a message soon.)

If you haven't responded its not too late. We would like to hear from as many members as possible. We are receiving lots of excellent feedback and good ideas. In fact, the topic of this Bulletin was suggested by one of our members on the survey form. We thought it was a good idea and we did it right away. We are listening and paying attention to your comments.

* * * * * FORUM Participation

We were surprised by how many members enjoyed our Bulletins but had never been to the FORUM section of our web site. There is a tremendous amount of good information there. I try to be an active participant and we have some very knowledgeable members who also contribute some excellent advice and observations. It's a nice friendly group (not live chat) and there is very little of the typical nonsense that is notorious on the web.

Come and have a look. I'm sure you will enjoy it. Go here:

http://www.traderclub.com/discus/board.html