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抰 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
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抰 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.
chandelier
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.
