Volatility Based Stops

Futures traders generally employ exit points in the form of volatility based stops for each position (established at initiation) determining when to cut a loss short and operating in conjunction with position sizing rules. These are in addition to the Exit Signals (described here) which attempt to define the end of the trend.

Many trend following systems (such as a dual moving average crossover) can not by their very nature establish a fixed exit level at the outset of a trade and hence additional stop loss rules are necessary both for position sizing purposes (“how much to buy”) and for capital preservation (to enable a fund to “cut its losses” when a trade goes against it).

The example set out below is by way of demonstration of the technique.  Volatility stops are often based on some multiple of the recent daily trading range of the instrument in question. A fund manager might reasonably assume that if he were to set his stop loss point for a long position at some multiple of the recent average daily trading range below his initial buying price, he would have a good chance of remaining outside the short term noise of the market. He would have the advantage of a wide protective stop which gives him every chance of running his profits (if the trade goes in his favor) but which would equally contain his loss if the position goes against him.

A commonly used calculation of the day’s trading range is the True Range. The True Range is a measure of volatility which indicates the range of price movement in a single day and is the greatest of:

• The current high minus the current low
• The current high minus the previous close
• The previous close minus the current low

The last two entries account for price gaps where the entire day’s prices do not overlap the previous day’s close. The True Range is then averaged over a number of days (20 by way of example) to arrive at the Average True Range (or ATR for short). A stop or pre-defined exit point can then be calculated for a long position by deducting from the entry price some multiple of the Average True Range.

Let us assume that an investor calculates his stop using a multiple of 5 times the 20 day ATR of the relevant instrument and that his system signals a long entry in June NYMEX Crude Oil to be taken on 6th May 2010. Prior to the market open, the system calculates 5 times the ATR at $10.62. Assuming an entry price of $80, the protective stop would be set at $69.38 (calculated as follows – $80 – $10.62).

A further advantage of the volatility based stop is the ability to size positions equally over different markets with reference to individual market volatility. At initiation of a trade, a fund manager risks the same fixed percentage of his fund’s equity on Corn as on Crude Oil, Gold or any other position.