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 MARKET REPORTS |
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Resident trader
How to profit from volatility - part 3
Will Kraa, November 5, 2007
Please note that neither CompareShares nor the author holds any interest in, nor derives any benefit from the software provider mentioned in this article, AmiBroker.
In the second article in this series on volatility, published two weeks ago we found out how to install the ATR volatility indicator and how it could indicate a change of trend. We now need to find out how to use it as part of a trading system to set up profitable trades. Used for trading CFDs the indicator is suitable for both long and short trades as mentioned previously. For those who want to trade shares only it can be used just to set up long trades.
The first thing to establish is that it is best to trade in the direction of the trend. While there may be times when a trade counter to a trend can be successful, it is a much harder way to achieve a good outcome. If a share is in a good uptrend it will probably continue to trend up - making it better to trade with the trend.
The long term moving average is the first filter we apply to select stocks to trade. I usually have a 150 Day (or 30 week on a weekly chart) Moving Average (150 DMA). Some people use an exponential moving average or choose some slightly different look-back period, but in the long run it probably makes little difference. For short term trades it may be useful to have a shorter term moving average but on the whole the 150 DMA seems to work quite well. The way we use this moving average here is to look for shares that are trading above a rising 150 DMA.
Some very experienced traders advise you never to buy a stock that is trading below a declining 150 DMA. I think this is very good advice. Conversely, if you are looking for stocks to short, look for stocks trading below a declining 150 DMA and donít go short in stocks trading above a rising 150 DMA. Using the 150 DMA in this way might means you miss out from time to time on trades that do well, but on the whole this is better if you thereby avoid a larger number of losing trades. It is all about looking for trades that give the greatest likelihood of being profitable. Trading with the trend helps to achieve that.
It is advisable to trade in the direction of the whole market as well as with the trend of the individual stock. Given that at the time of writing the market is in a very strong uptrend, most trades would be long trades (buying to enter the trade). For those who do not trade CFDs it is likely that all trades will be long, since it is not so easy to trade stocks short. In that case it may be necessary to trade counter to the direction of the market at times. Even in a declining market there are always a few stocks going up and finding them can lead to quite profitable trades. However they are not easy to find, so it pays to be very careful in a market that is not trending up.
We will assume that we are trading long for the purpose of illustrating the way the volatility indicator can be used. So have a look at the first chart of Bradken (BKN) during late 2006. The 150 DMA is sloping up nicely indicating the stock is in an uptrend so it is suitable for a long trade. The first entry signal on this chart is the day before the first blue arrow where the blue 2ATR (10) line "flip" (from candles being below the line to candles being above the line). If we entered a trade next day (19/06/06) at the opening it would be at about $5.05.
The next flip down of the indicator line is the day before the second blue arrow. The trade would therefore be closed the next day at the opening on 17/07/06 at about $5.15 for a profit of 10 cents, in percentage terms almost 2% in nearly a month. With the leverage available with CFDs the result would be better, most likely about 12% (you cannot just multiply by ten which is the leverage available if you use all the leverage possible you are trading right on the edge of trouble). This is better than a loss but it is very close to a break-even trade and could just as easily have been a loss.
About a week later the line again flips. In the intervening time the indicator was giving a signal for a short trade but because the stock is in an uptrend we do not go short. After this second buy signal on this chart we can open another trade on 28/07/06 at the first red arrow. Buying near the opening price gets us in at about $5.49. At first it looks like the trade is going counter to expectations but then it recovers and moves up to the next flip of the indicator line after two big black candles. We can exit the next day at the opening (second red arrow on 13/09/06) at $5.80.
This time we make a profit of 31 cents or 5.5% of the opening price and if using CFDs it is about 33%. Notice that in early October the trend resumes, making another trade possible. Even though profits were made in both trades there is something else to consider that indicates that these trades are not at all good trades.
In the first trade we got in at $5.05 but the initial stop would have been at the blue line below the trade at $4.86. This is a risk of 19 cents (or possibly more if there was some slippage) for a reward of only 10 cents. In other words the risk is almost twice the reward. The same is true of the second trade where the initial stop is at $5.04 and entry at $5.49 for a risk of 45 cents. With the exit at $5.80 it gives a reward of 31 cents and an exposure in the market of about 6 weeks. I have heard it said that you canít go broke taking profits but if the risk is too high you can certainly go broke taking profits. The profits are simply too small compared to the risk taken.
There has to be a better way and it is possibly seen in the second chart. Here the ATR multiple is increased to 3.5 and the trade now goes for much longer for a much improved profit. We can open the trade at the first arrow the day after the 3.5ATR(10) line flips for a long signal. We get in at about $5.60 on 07/07/06 and exit at the second arrow on 16/02/07 at about $9.10. The initial stop is at $4.96 for a risk of 59 cents and an end profit of $3.50. This is a profit of 62% or, if using CFDs, nearly 400%. The reward ($3.50) also is now 6 times the risk ($0.59) - a much healthier situation.
Although this is a much better trade we need to realize that the 3.5ATR(10) stop line will be further below the price action than the 2ATR(10). Of course that is what enables us to stay in the trade much longer. But it also means we are risking somewhat more capital or (later) profit. Near the end of this trade the price rose to a high of over $10 and we got out at $9.10. So we gave back almost $1 of our open profit before the trade was closed.
Even though this was a better trade there is still a problem when stocks are trading largely sideways or when prices move in an uptrend with fairly large swings in price. In such instances there can be a large number of unprofitable buy and sell signals with only the occasional prolonged trend without premature exit signals. It will not be easy to find the trades that are going to make a worthwhile profit just relying on the ATR line - even with the help of the 150 DMA.
Another method is to apply the strategy to a weekly chart. This will give longer term trades. In this case a 30 week MA needs to be used, as the 150 DMA on a weekly chart simply becomes a 150 Week MA. There is evidence that using the ATR on a weekly chart gives better signals than using it on a daily chart. Of course the trades will be longer but if you have the patience and aptitude for longer term trades this can be very profitable.
There is a system developed by Jim Berg that has been successfully applied by many traders and uses the ATR to give entry and exit signals. It is freely available but usually the coding given is for MetaStock. For those who have purchased AmiBroker there is code available which makes it very easy to use. This system does not rely only on the ATR indicator alone and so it tends to exclude some of the unprofitable signals.
In my next article I will describe this system and how to get the code for it and install it into AmiBroker.
In the meantime the ATR indicator can also be useful as a trailing stop for trades which are selected in other ways.
One way is to look for a stock where the Multiple Moving Averages are going up and have become nicely spread apart. (To install MMA in AmiBroker see the instructions below). Once the MMAs are well spread and not crossed and stay that way for a period, the stock is in a good uptrend and can simply be bought with the 2ATR(10) as a trailing stop. It is worthwhile to train yourself to look for the best MMA patterns by looking at lots of charts and working out where the patterns are most likely to be a useful indication of a good trend that is likely to continue.
The conventional wisdom is to look for a "signal" to enter the trade and this usually takes the form of a retracement followed by a resumption of the trend. There are some very good trends where this sort of thing does not happen very much and therefore a very good opportunity may be missed. The strategy I mentioned above helps guard against missing these very good uptrends and the ATR line provides a sensible exit for the trade.
Another way is to buy a stock making a new high and to use the ATR as a trailing stop.
For short trades look for a good set of MMAs going down and again use the 2ATR(10) above the price as an initial and then trailing stop.
If you have any questions remember to post them on the ‘Your 2 cents’ message board and I will endeavour to answer them.
Instructions for AmiBroker
To install the Guppy Multiple Moving Averages in AmiBroker go to
http://www.amibroker.com/library/list.php
and scroll down a fair way to ‘Guppy moving averages’. On the right hand side click on ‘Details’ and highlight and copy the coding under ‘Formula’.
Alternatively you can copy the coding given in ‘Comments’ as given below where it says ‘Details are:’
Follow the directions given in the previous article on this subject (two weeks ago) to save the coding as ‘Guppy MMA’ and I would suggest you put it on a sheet which you can call ‘MMA’ so it is readily available.
On the chart with your Chandelier, if you want to alter the multiple used with the ATR, right click on a chart with the ATR Chandelier indicator on it and click ‘Edit formula’. There you will find the line of code shown below:
Plot(ChandelierCl(ATR(10),2),"",colorBlue,styleLine);
As you can see the ATR(10) has a 2 after it which can be changed to suit whatever multiplier you want and if the colour is not to your liking, type in the colour you want. Just be careful not to change anything else, not so much as a comma unless you know what you are doing.
After changing click the ‘close’ button for the window and ‘yes’ to save changes.
If you have any trouble go to the ‘Your 2 cents’ message board on this site and ask for help. I can try to help with any problems you might have with AmiBroker if you post your questions on the message board.
More articles from this week's CompareShares newsletter:
Fundamentals: Telltale signs to sell that stock
Stocks: Another hot mining prospect
Smart investing: ATO toughens up on SMSFs
Resident Trader: How to profit from volatility - part 3
Stocks: Stock winners and losers from bullish currency
Stock of the week: Straits Resources weathers the storm
CFDs: ASX launches CFD exchange
Expert panel (CFDs): Top Ten CFD stocks for the week
Whatever your views, you can discuss this article - or any of Will's articles - on our message board Your 2 Cents.
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