A more accurate way to measure volatility for any market
Instead of the broad VIX reading, the most accurate way to measure volatility is using the Average True Range (ATR) indicator, introduced by J. Welles Wilder. The ATR measures how much a market is moving, taking into account any overnight gapping. This indicator is critical, as it can be applied to any time frame chart you are trading.

ATR calculation and different time frames
Calculating the ATR is as simple as applying the indicator to your chart on one of the popular charting programs, such as MT4, cTrader, Metastock or AmiBroker. However, it’s always good to have an understanding of the maths behind each indicator.

Below are the three values which are averaged to get the Average True Range:

• Today’s high minus today’s low
• Today’s high minus the previous close
• Today’s low minus the previous close

Once you have those figures, you take the average over a set number of periods. The default on most programs is 14, which accounts for two trading weeks on old charting programs ( which includes weekends). Today many modern traders use 10 as the default value as charting programs haven’t plotted weekends for decades.
More importantly, you can use the ATR reading on any time frame. So if you are charting on an hourly chart, then the ATR reading will look back over the last 10 periods (10 hours) and give you the average range over that period. Likewise for 5 minute charts or 1 minute charts.
Below is a chart of the ATR on the Euro Dollar on a daily chart. Note how much the volatility has spiked in recent months. The Forex market in the middle of this year had near record low volatility, but a number of factors have changed that, including the Russion/Ukraine tensions, ECB hinting at quantitative easing through a new bond purchasing program, and sanctions for Germany plus others. Together these events have pushed the average daily movement on the Euro Dollar up 250%, from 42 pips per day to 147 pips per day in 10 short weeks.

Applying the theory
How can you use the ATR in your trading:
1. Use the ATR to filter your opportunities.
2. Use the ATR to calculate your initial stop and trailing stop.

Let’s take a look at each in more detail.
1. Use the ATR to filter your opportunities
We have the greatest opportunity in the markets when they are moving, and when the volatility shrinks, so to does our opportunity. Therefore we can be more selective and only trade stocks, forex, commodities or indices when they are moving a certain amount on a daily basis and look elsewhere when they are extremely low in volatility.
As an example you could run daily scans across the entire ASX market and only trade those stocks that move at least 1% per day. In Metastock the code would be ATR(10)/Mov(C,10,S)>0.01 indicating that the 10 day ATR is moving at least 1% relative to the average closing price in the last 10 days. The same concept can be applied across forex, indices and commodities.

2. Use the ATR to calculate your initial stop and trailing stop
Knowing where to place your initial stop stumps a lot of traders, especially those who have the grand vision that all their trades are going to be instantly successful. Smart traders build an initial stop loss into their process so if the trade doesn’t work out, they can exit with their capital intact.
Ideally your initial stop needs to be more than 1 average daily movement or else (on average) you stand a very good chance of being stopped out on the same day. With an initial stop it is best to place it at a distance of at least 2 ATR. Here is an example and this is why it is so important to constantly monitor how much a market is moving.
On the 5th of August, the Euro Dollar was moving around 42 pips per day and the closing price was 1.3375, so if you were buying your stop calculation would be:
Stop = 1.3375 – 2*ATR
Stop = 1.3375 – (2*0.0042)
Stop = 1.3375 – 0.0084
Stop = 1.3291
Fast forward to October 16th and the Euro Dollar is now moving 147 pips per day. If you had maintained an initial stop of 42 pips, you would be well and truly within 1 average daily movement and likely to be constantly stopped out, ending in a great deal of frustration.

Applying it to your trailing stop loss
So now you know how to identify a reasonable initial stop loss, you can then start to apply the same technique to your trailing stops. The advantages are very clear. Instead of just using a set figure (ie 30 pips or 30 cents), you can now adjust your trailing stop, taking into account the volatility of the instrument you are trading, which, as shown above, can vary considerably.
Your trailing stop will kick in once your initial position moves enough in your favour to move past break-even. Then it’s simply a matter of trailing the 2-3 times ATR from the open, high, low or close and continue to raise it until you get taken out of the market, making sure to never lower your stop.
Understanding the volatility of the markets you are trading is critical and can help give you the additional tools needed to become a well-rounded trader. Be sure to apply this to your trading plan and I wish you every success going forward.

Ashley Jessen is the author of CFDs Made Simple and Director of Communications at Invast Financial Services, one of the largest global markets brokerage firms offering Forex, CFDs, Direct Equities and their proprietary ST24 platform.

In search of the Holy Grail

Expectations are a powerful thing and unfortunately, many trading related articles paint the illusion of the fast road to riches and incredible wealth by following a simple red line crossing above the green line. Often the expectation is set in place that the system you are about to purchase, the Expert Advisor (EA) you are about to download or the trading educator providing their ‘life’s work’ is going to be the Holy Grail, finally providing you with enough profits to say goodbye to the daily 9-to-5 grind. In reality, there is no Holy Grail when it comes to trading systems, but instead, successful trading is a combination of consistently identifying sensible risk reward opportunities with persistence and discipline.

What is the risk reward ratio?

In its most basic form, the risk reward ratio is exactly what it says on the box. It is the amount of potential reward, relative to the risk you take on. In the table below I’ve listed the various trading instruments with hypothetical stop loss and profit taking levels and the risk reward levels that these generate. By way of example, you can see the risk reward ratio is a function of the size of the stop versus the size of the potential reward.

Risk reward levels can be applied to all time frames across any asset class and can even be used for other investments as well – such as managed funds, property or business – but today we’ll be focused on applying this to our trading.

How do you calculate the risk reward for potential trades?

Calculating your risk reward is relatively simple and is often done using technical levels on your chart, such as support/resistance levels, Fibonacci, Average True Range (ATR), Ichi Moku and price projection based on chart patterns. While not exact, they do provide a method to determine the potential risk reward on your upcoming trading opportunities, allowing you to focus on those with the highest potential.

Three ways to take advantage of the risk reward ratio in your trading.

1. Only trade opportunities that meet your risk reward levels and are within your tolerance for risk

Ultimately you need to understand that you control when you pull the trigger to execute a trade, which means you are responsible for each trade you take. For the savvy trader, this is good news. You have the flexibility to take trades that meet your criteria and more importantly, reject those that aren’t up to scratch. Set a benchmark for trades you will accept, such as only trading those opportunities with a 1:2 or 1:3 risk reward ratio.

2. Remove the emotion from your trading

No trader enjoys being wrong, but since most trading systems are wrong 40-60% of all trades, some traders cannot help but get caught emotionally and let this deter them from taking the next trade. It is not uncommon for traders to be immobilised by the fear of loss and just the thought of executing the next trade is enough to induce a cold sweat, and in some extreme cases, being physically ill. By focusing on the risk reward of the trade and understanding the numbers of your trading system (percentage win and average size of wins compared to losses), traders are able to confidently take the next trade, knowing full well that the outcome is unknown but they have put the odds of a successful trade in their favour. This factor alone is one of the most powerful ways to gain control of your trading edge in the markets and will allow you to fully exploit the advantages you have built into your trading system.

3. Scale up once you have built the confidence in your trading system

You’ve now identified the risk reward of every trading opportunity and only take those that meet your strict criteria. You’ve also removed yourself emotionally from the thought of being right or wrong on the next trade. You’ve also managed to discipline yourself over the past six months with these principles and you’ve built up your confidence enough to scale up your capital base to the next level from your current base. Congratulations. This is the path of a mature, successful and constantly improving trader.

By applying the concept of risk reward when identifying your next possible trades, you have, over time, put the odds of success in your favour and are now able to allocate a sensible amount of risk to your trades, but at a higher level than before.  For example, when testing over the first six months, you allocated say $200 risk to every trade (1% of $20,000 capital base), just to test the validity of your system and to build confidence in your trading system. Now you have $50,000 in capital to allocate, of which you will still allocate 1% risk – but now it will be $500 per trade and your profitable trades will potentially be a multiple of your higher capital base.

Imagine doing this over a two-year period, building confidence in your system(s) every six months and upon evaluation, considering whether you can scale up to the next level, always staying within a dollar risk amount that allows you to sleep comfortably at night. What level of trader would you be two years from now or perhaps five years from now?

Hopefully those are motivating thoughts and inspire you to utilise the power of risk reward ratios in your trading and more than surpass your trading goals and financial objectives well into your future.

Ashley Jessen is the author of CFDs Made Simple and Director of Communications at Invast Financial Services, one of the largest global markets brokerage firms offering Forex, CFDs, Direct Equities and their proprietary ST24 platform.

Today we are going to uncover some of the key misconceptions around leverage and how you can use it in a sensible manner.

So what is leverage?

Leverage is used by the majority of the western world’s population in their day-to-day lives without barely a thought of the potential risk involved – I’m talking specifically about your home loan. Lenders require a small deposit of around 10% in order to secure a $500,000 home, so your $50,000 is now leveraged (10 times) and controlling a hefty half a million dollar asset. Major metropolitan house prices in Australia have continued to rise recently, so let’s say your home appreciates by 10%. At this stage your home is now worth $550,000 (albeit on paper) and you’ve made $50,000 (or 100%) on your initial $50,000 outlay. This is leverage, and the concept applies in a similar fashion when trading forex.

Leverage in the forex and CFD market

Leverage in the forex and CFD market allows you the opportunity to access larger positions with your initial capital than what you might normally be able to when trading unleveraged instruments such as stocks. Archimedes once said: “Give me a lever long enough and the fulcrum on which to place it, and I shall move the world”. Despite this potential, initially your goal is to appreciate the power of leverage, understand how it may fit in with your financial objectives and use just enough to meet your financial goals.

Leverage example on the AUDUSD

When trading forex there are three main position sizes you will need to consider when taking a position.

Position sizes are extremely flexible and allow you to trade as little as 1 micro lot or a total position size of $1,000 (with a mere $10 held with your broker to cover the margin), which is perfect for those looking to test their strategies without risking the farm so to speak. Nothing beats live trading (as opposed to a free demo account) as the lessons learned are heightened due to real money in the game.

400 times leverage? This is not how you work out your leverage!

A common misconception we hear time and time again is that the forex market is risky because you can trade up to 400 times your account size. Many forex brokers only require you to place a 0.25% margin up front (as opposed to 1% in the table above) in order to control your full position, so trading a $100,000 position would require $250 of your own money.

The only thing that truly matters is how much your account is leveraged and how much risk you have relative to your overall account size. So let’s consider how to apply leverage on your account in a sensible fashion whilst keeping your overall risk on the account at low levels.

Broadly speaking, if you were to find a Forex, CFD or even a share trading system that achieved a 5 per cent return per annum and applied 3 times leverage, then your end-of-year return on investment (ROI) would be 15%. Similarly if the system lost 5% at 3 times leverage then you would be down 15% at the end of the year.

Out of control

So why do we occasionally hear stories in the newspaper about how leveraged products are apparently considered risky? This doesn’t seem right when:

• The trader controls how much leverage they access
• The trader chooses the market(s) they trade
• The trader chooses the trade setups
• The trader sets the stop loss levels
• The broker simply offers a platform and leverage opportunity for traders to access.

Unfortunately we gloss over the real reasons as to how the trader got in this position, which often comes down to greed, lack of a trading plan and an expectation that trading is a sure-fire path to untold riches.

As a reader of Trader Plus you are already positioned as someone with a sound mindset and the ability to think for yourself, so here are some tips on how you can use and access leverage in a sensible fashion.

Five tips to use leverage in a responsible manner

1. You control how much you leverage your account. The broker does not control this. Understand how much leverage you are using and maintain discipline in keeping that low.
2. Understand how much you are risking per trade relative to your overall trading account and never risk more than 1-2% of your account on any one trade at any one time.
3. Never over leverage, as this is the fastest way to wipe out your trading account. It is your responsibility to keep your account intact and trade within the guidelines you set in your trading plan.
4. Pretend that every trading decision you make has to be approved by an investment panel whereby you are controlling the funds of hundreds of trading accounts. Capital preservation should be your top priority.
5. Plan for worst case scenarios and set daily and monthly limits. Understand your daily exposure levels and be disciplined to not exceed these.

Trading the forex markets is a lot more interesting when you are trading within your limits and executing a well thought out trading plan, which will hopefully allow you to incrementally head towards your trading goals.

Ashley Jessen is the author of CFDs Made Simple and Director of Communications at Invast Financial Services, one of the largest global markets brokerage firms offering Forex, CFDs, Direct Equities and their proprietary ST24 platform.