By Andrew Gibbs • Jul 9th, 2009 • Category: Systems Trading
by Andrew Gibbs
In part 1 we utilized the volatility breakout system for entering the market as it starts to rally above the stock or futures opening price for the day. This method allow us to get momentum working in our favour prior to entering a new position. Given that the method has a positive expectancy on its own can we use it for exiting the market as well and for setting a stop-loss. The thing about stocks and futures is that they are volatile and can really make some big swings during the trading day so you need to allow the market plenty of room to maneuver. This is the reason why we trade with relatively wide stops.
The Stop Loss
The definition or term “stop loss” is a misnomer. A stop loss does not prevent you from taking a loss, but rather limits your loss at a pre-defined level. It is a point at which you exit a losing trade.
Purpose – A predefined exit that takes you out of a losing trade to prevent a larger loss from occurring.
Stop losses are always a trade off. The tighter the stop loss you have the larger your win:loss ratio will be, but you will not win as often and the result is that you will have a low percentage of winning trades. It is the exact opposite with a wide stop loss, you will end up with a high percentage of winning trades however you will end up with a low win:loss ratio. I like to use something in the middle, I like a method that wins more than 60% of the time but the wins have to be larger than the losses. For example most of the trading systems you will learn win approximately 65% of the time with wins usually about the same size as losses, on average.
Setting a stop loss based on volatility
In part 1 we looked at using 20% of the previous XX (6 in the example) day range to determine how far above the opening price we would set our trigger level to buy into the market. In this example we are going to set a stop loss for our method at 70% of the previous average 6 day range below our entry price.
S&P 500 futures example
In the example in part 1 we calculated the average day range on the S&P futures as being 15.2. Now we can set a stop loss based upon a number of factors, but in the example below we will use 70% of the average 7 day range, or 70% of 15.2 which comes to 10.64 points. So the stop loss will be set 10.64 points (rounded to 10.75) below our entry price. If we enter at 1000 the stop will be set at 989.25. We use between 70% and 120% of the average 7 day range to set our stop loss distance in our trading systems.
CBA – Commonwealth Bank of Australia Example
If we refer back to our CBA example in part 1 where we worked through the calculations for average range we came up with an average range of 90 cents. If we take 70% of the value it works out to be 63 cents so if we were to enter a new trade we would set a stop loss at 63 cents below our entry price. This distance gives the price a little room to move, whilst getting us out of a bad position relatively quickly. For instance, if the market opens at $40.00 and we enter our trade at $40.18 our stop loss would be $39.55. ($40.18 minus 63 cents). This means if the price drops to $39.55 or below we exit our position.
The stop loss distance changes every day so you need a good software package to tell you what these values will be each day so that you can calculate them in a quick and efficient manner, thus saving you time. If your software package does not have a range indicator you can also utilise the 7 day average true range, which is a common indicator in most software packages.
Setting an exit based upon volatility
The exit we utilise is known as a trailing stop, but we utilise it differently to the way most people utilise a trailing stop. This method is an adaptation of the famous “Larry Williams Bailout Exit” technique, which involves exiting the market on the first profitable open. The exit technique we use is that firstly the market must open in profit, but rather than just exiting the market on the open we set a stop loss at between 15% and 35% (depending on the market traded) of the average range below the opening price. Remember in our CBA example where we calculated the average range to be 90 cents? In this example we are going to take 15% of the average range of 90 cents, which is approximately 14 cents and we are going to setup a stop loss below the opening price after being in the position for 24 hours, but only if the market opens above our entry price. If the market opens below our entry price we will continue to run the stop loss from at the same level previous day when we entered the trade.
It is the same on the S&P 500. Let’s say we exit a winning position at the opening price less 25% of the average 7 day range, how do we do this. Firstly, if we are long the S&P from 1000 and the following day the market open at 1010, we calculate the 25% of the average 7 day range (which was 15.2 points in our part 1 article) we get 3.8 points, rounded to 3.75 points so we would move our trailing stop to 1010-3.75 or 1006.25. The result is that if the market opens on its lows we are in for the ride, however we cut the trade very quickly if the market starts moving in the wrong dirction.
Why do we do this and not just take our profit on the open? The answer is that sometimes the market will open on its low for the day and keep trading higher, in which case we hang on for the ride. This allows us to let profits run, whilst it cuts losses early. The graphic below shows this exit technique in action.
In the example above we have shown you an example on CBA of a situation where the market has opened near the low of the day and how the trailing stop technique has kept us in the trade right throughout the second day of the trade. In this trade example we would have held the position right through until day three where we would have exited somewhere below the opening price as shown in the example below:
The profit on this particular example on CBA is $5.69 per share or 14.5% in just over 2 days.
A further example of this trade technique in action is shown below:
SPI 200 Index Futures
The SPI 200 is the equity futures contract in Australia. It is very similar to the S&P 500, however it illustrates the movements in the top 200 shareslisted on the Australian Stock Exchange (ASX). In the graph below we have displayed 7 examples of the volatility breakout entry and exit technique on the SPI 200 futures following one of our trade setups that we will outline in a future article.
This particular trade setup, combined with a volatility breakout made money by trading the “long side” of the market in a bear market. The trick was to wait for a large fall in the US markets overnight and then to buy on a volatility breakout in the Australian market the following day.
On setting profit targets
We do not set profit targets wit our system, the market plays itself out and dictates the amount of profit we make or lose. If we set a profit objective this cuts the winning trades early, something you do not want to be doing. By using the trailing stop technique we are letting our profits run, which is something we try to remember when this exit technique keeps us in a profitable trade, which opens in a loss the following day, however overall, in all of our system-testing we are yet to find an instance where you are better to set a profit target rather than use the method outlined above.
Please make sure you thoroughly understand the method above as it is the core trading method for entering and exiting the market on almost all of our trades. The following lessons in this course are designed to create setup opportunities for using the method so that we are only trading the very best opportunities.
In part 3 we will look at how to utilise these methods for trading the short side of the market as well.
CLICK HERE FOR PART 1 OF THIS SERIES
