In the middle of this year, Forex volatility was near all-time record lows and within a few short months, volatility on the Euro Dollar had increased by more than 250%, S&P500 volatility was up more than 110% and even BHP Billiton’s average daily movement had increased by more than 60%. What protective measures could you put in place? How can you potentially take advantage of these volatility markets? Today we’ll answer both of these key questions.
One way to measure volatility
Futures and Options traders will be quite comfortable in referring to the Volatility Index, or what traders commonly refer to as the VIX. The VIX gives a broad reading and measures implied volatility over the next 30 days and unfortunately for most active traders, this is of little benefit, except to use as a gauge of fear and complacency among market participants. A low VIX is typical of complacency and, in general, bull markets, whereas a high reading is indicative of fear, suggesting options traders are buying protective puts (making money as markets fall) to hedge their long portfolio. Incidentally, the VIX index can be traded and is a very hot trading instrument when markets are fearful.
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.|