, 2658when you wait until they are hit, you may see a rather nice gain turn 2648into a loss. | 2638| aNatural stops are of little or no use in non-trending markets. | | | 26182688The next chart gives you an idea of what | mean when | say a i 2598natural support point may be too far removed from the current price | 2588action. {| | > © Support closer 2578to price action, 2569| | 2558f 25482538| L Not natural 2528
support. Prices 2518did not hold there. 249
| } < Natural support, 4
 
247824681 245824482438
 
Wal
 
NOU DEC JAN
 
134 135Volatility Stops
In my experience, other than natural support and resistancepoints, the market has only one other factor to aid in stopplacement. That factor is volatility.
To understand how to use volatility you first need tounderstand the concept of volatility.
The difference between a bar's high and low price is that bar'strading range. You can use the high and low of a week to get aweekly range, or you can go intraday to look at hourly, 15 minute,or the trading range of any e period. You simply subtract the lowfrom the high for that period. When you look at any bar chart, thelength of each bar, from high to low, represents that bar's (orperiod's) range.
 
Once you have the range for one period, you can do the samecalculation for any number of sequential periods, and then take anaverage. If you want to look at the range over a five bar period, yousubtract the low from the high of each bar, and after five bars youadd up all five individual bars' ranges, then divide by five to get thefive bar average range. However, there's a complication.
Let's say that you have a gap up opening, and the low for thecurrent bar ends up being higher than the previous bar's close. If weassume the range to be high minus low, then what happens to thegap, the distance that the market moved between the previous bar'sclose and the current low?
The true range must include the distance from the previousbar's close to the current bar's high. Conversely, when there is adown gap, and the current bar's high is lower than the previousbar's close, the true range is equal to the difference between theprevious bar's close and the current bar's low.
There is yet another complicated consideration. What do youdo about markets that trade elsewhere, or are affected by tradingelsewhere, and the result is often a large gap opening due to theprice action that has taken place overnight?
136
 
You must decide for yourself whether or not to take that kindof gap into consideration in your calculation of volatility. Theanswer may be that you count gaps in some markets and not inothers.
Once you learn how to calculate a bar's true range ‘with orwithout gap considerations, you can take an average over anyselected number of days to come up with the true average range.
The true average range is a direct measurement of themarket's volatility. When daily ranges expand, we are seeingincreased volatility come into the market. When ranges decrease, sdoes volatility.
If a market is very volatile, a stop based upon that samevolatility will give a good indication of where to place the stop.
There are a number of ways to compute a volatility stop. Ineach case, we must first come up with a volatility figure.
In my own trading, | use average volatility for the last five pricebars, provided they are reasonably the same in size relative to oneanother. If there is an abnormally large, or an abnormally smailprice bar, | will compute average volatility for the last ten bars. Asmuch as possible, | want to eliminate any aberrations in the market
place.
 
| use ten or more days in markets that have a lot of gaps.
To compute average volatility for any number of days — N, |take the sum of the differences between the high and the low for Ndays, and divide by N. | then have the average volatility for the lastN days.
 
give an example using the bonds. If you can figure averagevolatility for the bonds, you can do it for anything. When | computeanything that has to do with the bonds, | first convert them todecimal.
137To accomplish that | multiply by 32 and then add the 32nd's:
Day High Low Conversion Difference103-20 103-08 3316 - 3304 12103-16 103-02 3312-3298 14103-14 102-19 3310 - 3283 27102-27 101-29 3291 - 3261 30101-29 100-28 3261 - 3228 33
aOhWN=
Total 116 /5 = 23.2 AV
| then subtract the average volatility point from my entry price,to obtain a logical price at which to place my initial protective stop.
If | were to go long the bonds at 103-14, | would subtract23/32 from my entry price and place the stop at 102-23.
In order to be consistent and also to show you how | convertback from decimal to 32nds, note the following steps.
103-14 = 3310 - 23 = 3287.
To convert back, you divide 3287 by 32. This gives a wholenumber and usually a fraction expressed as a decimal, NNN.xxx
You then subtract the whole number away. This will be themantissa (whole number) to use for your order.
You then multiply the fraction by 32. This gives the remainingthirty-seconds if any for the remainder of your order.
3287/32 = 102.71875 - 102 = .71875..71875 x 32 = 23Result = 102-23.
It's important to notice that there is a flaw in this method of
computing volatility. There's something missing. Can you guesswhat it might be?
138
 
 
Gaps are missing from this calculation. In the currencies, onthe daily chart especially, this leaves a lot of the market missingfrom the calculation.
The truth is that on a gap day, prices have moved from wherewe see the close today to where we see the open the following day.
There are two sides to the argument. One says that regardlessof the gaps, prices are only volatile to the extent that we see themarket move each day during the hours we trade. The other sidesays that to compute true volatility, you must include the netamount of the gap. In an up market that would be the distance fromtoday's close to tomorrow's open. In a down market it would be thedistance from today's close to tomorrow's open. On intraday chartsit doesn't really matter.
You should try to calculate volatility both ways and see whichmethod suits you best. For my own purposes, | have left out thegaps. But you need to be aware that they are there, and they maybe more important in some markets than in others. That is thereason | compute a ten bar, or more, volatility on daily charts thatcontain many gaps.
| have set my stops both according to natural support andresistance points, and computing volatility as shown, over most ofmy trading career. It wasn't until | came across the Volatility Stopstudy contained within Howard Arrington's very fine Ensignprogram, that | began to consider another way to set stops.
The Volatility Stop Study
One of the more interesting ways to set stops using volatility isto utilize the study called the Volatility Stop.
| have adjusted this study to my own liking by occasionallyremoving the multiplier that is normally a part of the study.However, the multiplier can be used effectively in a more volatilemarket to curve fit the study to the greater volatility occurring inthat market.
 
  
139To use the Volatility Stop study, simply compute averagevolatility and then add the figure to the lowest close in the last Ndays, and subtract it from the highest close in the last N days.
This will yield two prices, one for upper volatility and one forlower volatility. Typically, one of the figures will be a price that iswithin the range of prices you see on your chart for the last N days.The other figure will be either above or below the range of pricesyou see on your chart. You want to use the price that is furthestaway from the range of prices for your stop.
Rather than try to explain further, I'll show you a picture of theVolatility Stop study. If you have such a study available, simply setthe multiplier to 1 to put it out of commission, or experiment withthe multiplier until you get a plot that contains the move.
140
 
  
CL G DAILY23752388fh es2275© out on2288ty i 2a1\ Le. <- outwet Ht 2125{ 2168The volatility stop study contained 2875the nove up, You vere not stopped | 2858out until just after the first top. | out 2825On the nove down, you vould have been i anstopped out three tines before the final 4 1958tine at the botton, | 1925AV for 1988the next 1875| bar 18581825188817751758‘SEP crete tates
 
Volatility for the above study was set at 5,1. The 1 takesaway any multiplier.
An interesting thing about the Volatility Stop study is that it iscomputed and plotted at the completion of each bar such that youknow where the stop is for the next bar. It is displayed forward.On the preceding chart you see it sticking out by the arrow.
 
When Average Volatility (AV) is running through the pricerange, it is a sign to avoid entry into the market, unless of courseyou want to trade in the congestion.
141 
Here is an interesting way to use the Volatility Stop (VS)study.
Since a setting of 5,1 contained the upmove, you would leavethat setting in place for the down move.
However, once the down move failed to be contained by thestudy, you could try setting the multiplier to a number greater than1.
Here's how you would do it.
CL & DAILY 2184Price exceeded the VS plot at Point a.
you could have curve-fit the VS plot |
so that it “contained” the move at
the high of the bar in which Point a |
occurred.
The chart on the following page [ (l
illustrates how the curve-
        
fitted US plot would look. |
|
  
fh 4b
 
vote tiene HEE EEE EEL Eber EEE |
valli llSEP OCT NOU89-26 O- 2171 H- 2173 L- 2162 C- 2171 V- 1977 I- 17288
142
23582348233823282318238822582288227822682258224822382228221822882198218821782168215821482138212821182188
 
Is there anything wrong with curve fitting in this manner? |
think not.
After all, we want to cooperate with the market. If the
volatility is such that a 5,1 VS study is not able to contain priceaction, then set up a study that will contain it. The market is always
right, the only one wrong is you! You must adjust to what the
market is doing, not what you want to force it to do.
CL 6 DAILY
Having arrived at a curve-fitnultiplier of 1.7 for a S-day
period, the VS study now“contains” the entire down
nove.
roo tl btir tiieocr
 
|
 
           
  
||[I{
Notice hou the VS plotcontains the move all the
next chart.
143
Hh,
way to the last bar on the Rh
Hil
Cb
7387Ha233823282318
21182188| like to see a little room between the high and the VS study.
Remember that if the stop is too far away, you don't have totrade. No one is twisting your arm to make you take the trade.
| prefer to fit the study to the market when | have made someprofits.
Then it's my decision whether or not | want to risk thoseprofits. .
A good rule of thumb is that if the VS study would cause youto lose more than you've made, then it might be better to chip awayat the market until you do have enough to risk the amount dictatedby the study.
CL G DAILY Y 5,1.7» 2375
1I’ve set the multiplierto12, oe
      
  
vit 1
The entire nove is contained by thestudy,
 
144
 
Isn't this a much more intelligent way to set stops than to justuse some fixed number of points, dollars, or percentages that have
no real meaning?
Once you see that the market is in an established trend, simplyride that trend. The concept here is to wait for commitment by themarket. Once you have it, hang on for the ride.
This type of trading is a lot better than jumping in and out all ofthe time. We are letting the market tell us how far away to place
the stop.
In the introduction to this book | mentioned that day tradersleave more money on the table than do daily position traders. | saidthat while a market may be wonderfully trending, the day tradershave to battle their way into the market each and every day, oftenlosing while the daily traders are making piles of money staying withthe trend.
Since this is a chapter on stops, let's realize that one way toget stopped out of a market is to be purely a day trader. When youmake the decision to daytrade exclusively, you have made thedecision to stop yourself out of the market.
To my way of thinking, this is tantamount to closing a toystore in the month of December.| have repeatedly shown you a Crude Oil chart in this book.While scads of money were being made by the daily position traders,there were plenty of days that looked like the chart below on anintraday basis.
CL GS MIN
Lots of money was made while this market trendedi each day, yet daytraders had little opportunityto make money intraday. Much of the action cane
hu in the forn of overnight gaps.
The currencies are famous for thistype of intraday action.
 
89 181112 1 29 1811121 3 1811121 2891811121 29 18 11 121
146
 
Here's a D-Mark intraday chart. It, too, shows that most ofthe movement came as a result of gaps. This happened during astrongly uptrending market on the daily chart.
DM HS MIN
 
9 1811121 2891811121 29 1811121 289181112 1 11118
The point I'm trying to make here is that a lot of traders end upstopping themselves out of a market when there is no need to do
that.
| believe in a balanced approach to trading. Every time youenter a trade, you are going into business. When you get stoppedout, you are out of business. It's bad enough that we are put out ofbusiness more often than we care to be. Taking yourself out of amarket that is making you money seems to me to be the height of
foolishness.
147This is the type of rigidity that has nothing to do with goodtrading. When you say to yourself, "I'm a daytrader, therefore |must be out by the close," you are being rigid in a way that may beharmful to your success. If you don't get the big wins, how can youever make up for the small losses?
Probably the oldest saying in the business is to let yourwinners run. If you stop yourself out of the market you are ignoringthis most basic of principles.
Of course, there may be an overriding reason to be strictly aday trader. If you simply cannot stand the pressure of holding atrade overnight, then by all means you should restrict all trading sothat you are out by the close. Comfort in trading is more importantthan money. If you have a problem with staying overnight, you willjust have to leave that money there for me to pick up.
The only market | will purely daytrade is the S&P. | am notwilling to put up so much money ($22,000 as | write this) percontract for the privilege of staying overnight. Sufficient money canbe made by simply daytrading the S&P.
I'm not much for holding the Bonds overnight, but for adifferent reason. The Bonds simply don't trend sufficiently towarrant overnight po: ns most of the time.
 
148
 
Chapter 11
Placing Objective StopsGood planning dictates that you should have some sort ofobjective for at least a part of your position. | use a three stepapproach to placing objective stops.
Cost Covering Stop
 
. Cost covering objective stop.
For me, it is important that | cover costs. This single, simpleidea has been one of the most important concepts of my success inthe markets.
| havethe
I never allow myself the luxury of counting profits uncovered my costs. As long as | take care of that one detprofits seem to take care of themselves.
  
By covering costs, | mean taking care only of the immediatecosts of the trade — commissions and fees.
1 do this in conjunction with market volatility. Volatility mustbe equal to at least twice my immediate costs or | will not trade.
That means unless | have a chance to cover costs with nomore than half my position, | will not trade. An exception to thisrule would be if | were trading three contracts. Then | would wantto be able to cover with one or two contracts.
Let's assume | want to get long a day trade in the S&P using afive minute chart, and that my costs are $25 per contract, and that |am going to do a three lot.
| would need $75 to cover costs. Since a single tick in theS&P is worth $25, | would need six ticks of average volatility inorder to meet my rule of the volatility being twice my immediatecosts.
  
 
149Why twice my costs rather than some other multiple? Or whyany multiple at all?
The reason for a multiple of two is the propensity for prices tooverlap.
Take a look at what follows:Rh
<-— Spent monentun.
If I were looking for a breakoutof the Rh, it’s clear that apart of the monentun of the Prices have a tendency toprice action will be used up over lap.
Just in getting to the
breakout point. t
By using twice the volatility as the least amount of volatilitywith which I'm willing to enter a trade, | increase my chances ofreaching my objective of covering my costs.
These stops, where possible, are placed as "market if touched"
(MIT) orders.Small Profit Stop
2. Small profit objective stop.
Once | have covered costs, I try to take some sort of profit.Depending upon observable market action, | may take that profit atthe same price at which | cover costs. Whenever possible, | attemptto take the profit at a better price than costs, but that is not alwayspossible. How do | tell?
150
 
 
If a market has been moving strongly prior to my entry into atrade, especially if it has been trending well in a time frame that islonger than the one in which I'm trading, | will have resting MITorders for only that number of contracts that enable me to covercosts. My first profit stop will be set at an amount which is dictatedby average market volatility. For example, if | need six ticks tocover my costs, and average market volatility is thirteen ticks, then |will have a resting, cost covering MIT, at six ticks and a resting,small profit MIT, six or seven ticks beyond my cost covering MIT
stop.
The point of all this is to avoid a situation where | have noprofit to show for my having taken the risk of market entry.
Full Profit Stop
3. Full profit objective stop. My third objective is to captureas much of the move as the market will allow. This is done with atrailing stop. In other words, my objective is to be stopped out.There are two considerations here.
A. Until | am satisfied in my own mind that the market isnow trending, or is going to trend strongly, | will trail a 50% stop.When | am convinced | am in a strong trend, then | can do a numberof things which will be covered in the next section under trailing
stops.
B. When | am satisfied that I've made a nice profit, and
feel there is no way | can be terribly hurt, | wistop in favor of giving the market all the room | am comfortable in
allowing.
 
Trailing Stops
As stated previously, | trail a 50% stop until | feel as though |can take a chance on allowing the market a lot of room.
There are at least three ways | can do this, and | use them asthe mood strikes me. A fourth way exists, but | reveal this only atmy seminars. However, these three ways are all excellent and | stilluse them according to my perception of the market action.
1511. Natural Support and Resistance. I've already mentionedthis but in a different context. Natural support and resistance pointsare superb stop placement points in steeply trending markets. Theuse of them is a judgment call — you have to look at the marketanatomy and see if they have been working in this market, both inpast trends and in the current trend. If they have been workingwell, use them. This is the simplest, least complicated way oftrailing a stop. It requires that you know the market in which youare trading. You come to "know" it by studying its history.
2. The Volatility Stop study, which is available in some tradingprograms, and which can easily be computed by hand. TheVolatility Stop study and how to compute it is covered elsewhere inthis book.
3. Curve fitting a moving average to a trend. This is done inthe same manner as | showed for curve fitting the Volatility StopStudy. Study the charts that follow. There are some importantlessons to be learned.
 
152
 
 
Vhenever you have a chart that contains a narket aberration <caused by sone unusual event, political, clinatic, etc.,
remove those bars from your chart so they don’t skew your
Perception of the warket or ruin the results of your
studies.
iM vetal ie
if
© Politically caused market aberration.
M
Se SBSESUSSERSELERS ae eeeE
   
“we TN UWL AUS” OCT. NOU.
Simply remove the offending bars from your chart. They donot reflect the true, overall action in the market, but they will givefalse readings to any technical studies you may have on your chart.
In the charts that follow, you will see | do what | Say.
153After auhile, I nay have built up substantial profits. Then the market madea rather strong correction and began to move up once again, with the angleof ascent becoming soneuhat steeper. If I were in this narket, and if I werewilling to risk sone of the profits I’ve already made, I could curve fit awoving average to the major correction low and set a trailing stap justbeyond the price level of the noving average. <
427542884125
i #05
Suppose I had peentered this
warket on the sy 1 3688takeout of a i,! 3825Rh five days 3458
after the Rh 3375
was formed. iy Ls af 3388wt atly al aWi 38253a88
|Kye Also suppose that my stop was placed ata aonatural support point. 25
    
&- 5A bar Moving Average of theClose.
Suppose, too, that as the market trended I was stopped out from time to 2788time vith small wins, by trailing a 5B% stop. 2h2525582475
tRURSIRRSSENSSSHESARRIBASS
“WU
    
In the above fictitious situation, the market is trending steadilybut not steeply. Although | might have used an initial stop set at anatural support point, the market action, and the shallow angle ofthe trend, would dictate that a 50% trailing stop be used.
Although | used a 54 bar moving average of the close, thereare a number of other MAC's that would have given similar results.In addition, | could have used a moving average of the lows, sinceIn other words, this market is not exactly running away. It is this is an uptrend. fh it hae been a downtrend | could have used aplodding along. moving average of the highs.There's no magic in these moving averages. | use them only to
show containment of a trend.
154 155
 Perhaps, you could have used a volatility stop with a largemultiplier to show this containment. Offset Moving Averages couldhave been used. You might even have drawn an old fashioned trendline!
Other Considerations
Profit Objectives Using Points
If | am able to cover costs with one-third of my position, | woften take profits based on making a certain number of points. Forinstance, if | have made five points to cover costs on an intradaytrade, | may take some profits by liquidating a part of my positionwhen I see another five points. This, too, may be placed as an MITorder.
 
There are certain trades that are designed as short term scalps.| will very often have a profit objective based upon points for thesetrades.
Some markets lend themselves to the concept of setting pointobjectives. In the S&P, you can get fifty points on most breakouttrades involving intraday hooks on a five minute chart. At fiftypoints in the S&P, | will take some profits, and then pull myprotective stop to breakeven. If the market continues to move, | willmake even more, but | almost always am able to take the fiftypoints.
Point objectives may be adjusted upward for time framesgreater than five minutes, but keep in mind the volatility of themarket and time frame you are dealing with. You wouldn't expectan objective of fifty points on a daily Bean Oil chart. It may takeBean Oil two or more days to move that far.
Using Fibonacci Expansion ObjectivesThe use of this type of objective has been pretty muchhammered to death in recent years. It has been written up
repeatedly. How to use these are described in Part | of my bookentitled Trading by the Book. |
156
 
| use Fibonacci objectives to project the expansion from atrading range. They can also be used in trending markets. Objectivestops can be set at these objective points because they tend to beself-fulfilling when enough people use them in a market.
That in itself is a reason to know where they are. Whenenough people are using them, you will know where to expectreactions in certain markets.
For instance, Fibonacci traders abound in the U.S. TreasuryBond and S&P 500 markets. This is especially true intraday. Youcan pretty much tell where these traders will be looking for profits.If you see a market moving to Fibonacci expansion ratios, you canuse these ratios to your own advantage. You will be able toforecast market moves with fairly good accuracy. Not only can youtake profits there, but you can make good counter-trend, short-termscalps at those expansion levels.
157Here's how to do it.
Vhen you see a market naking a Jeg up, a correction, and thena resunption of the trend by taking out the Rh, you can expectprofit taking at one of three places.
     
-2a
 
Heasure theheight of theleg fron A to B ->Then project moves to618, 1.88, and then 1.618expansions from point c. .The fornulas for each are:yee £18 @-A)+CA 1,888 (B- A) +C
1618 (B- A) +C
| do not use money objectives. | have trained myself to thinkof my trades in terms of points. When | do that, the money takescare of itself. | firmly believe that you do not count your moneyuntil the trade is over.
| do not use percentage objectives. | think it's rather foolish toattempt to dictate to a market that it must move a certainpercentage. However, if Fibonacci ratios can be deemed to bepercentages, | take advantage of those ratios by scalping intothem in markets where | have determined that many other tradersare using them.
 
158
 
Placing a Profit Protecting Stop
Taking profits from a market while they are there to be had is avery important part of my money management when trading theRoss hook.
Any of the trailing stop methods can be used. The idea is tomake sure you get out with a profit. By using a profit protectingstop, you will not fall into the trap of seeing the prof in a tradedisappear and turn into a loss. By trailing a 50% stop in the earlystages of a trade, you make a decent profit on most of your
trades.
 
 
There is a time to lift the 50% trailing stop. One instance iswhen you decide to let the market run, and place a stop far backusing one of the trailing stop methods I've described. The other iswhen you decide to get out before your 50% stop is hit because ofthe price action you are seeing in the market.
This decision is normally made at a short to intermediate term
phase of the trade.
fi good place to consider abandoning the SBtrailing stop in favor of simply taking profitsis right after a gap or a large bar move. o>)
: ff =Sax >. | I | nes2 " aPijeum | ah ly 4 2475| tt 7425| ft 7375het acl isi ! iM [af 1225| i" | it you were long as shown, why wait around to 2225Id 1 ones'goucan Identify congestion. tou can 7208almost aluays get back in if the trend resumes.159In other words, in the early or intermediate stages of a trade beaware of the market going into congestion. At the end of thecongestion, or even at some point during the congestion, prices maymove to your 50% stop, and you will have given up more thannecessary.
Don't feel "honor bound”, or in any way compelled to staywith a trailing stop if it doesn't seem to make sense. Take profits!
Here ve see a reaction to a large bar move.Wisdom dictates getting out as soon as thecongestion is detectable, if that happensbefore the 58x stop is hit.
Once the congestion is detected, in this case by the end of the fourth bar,the stop should be moved down to 1 tick above the high of the fourth (nd
do ji) bar. | Hl
\ I
| * a bar
i Fj h | rmi"
WkI,i
I LJ Congestion after the large bar is{ 1 detectable by virtue of alternation i
BERSR