TRADING WITH VOLATILITY

INDICATORS
Many traders use volatility indicators to help determine a securities direction,
strength and momentum. One of the most popular volatility indicators is Average
True Range (ATR). ATR measures volatility by averaging price ranges over a set
time period while taking into account trading gaps. The True Range indicator is
defined as the greatest of the following for each period:

The distance from today's high to today's low.

The distance from yesterday's close to today's high.
The distance from yesterday's close to today's low.

The Average True Range is the average of the true ranges over the past x periods,
where x is specified by the user. ATR is available in most good software packages
and is often dropped over the top of a bar chart as in Chart 1.

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AUSTRALIAN STOCK EXCHANGE (ASX)

CHART 1

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The most common analysis of ATR volatility wo uld focus on volatility at tops and
bottoms and during price consolidation and retracements, but combining ATR in a
few simple formulas will help traders target specific price areas for entry signals,
trailing stops and profit taking opportunities.
My ATR volatility analysis is applied only to securities that are in a rising trend, as
this is the path of least resistance. I want to buy securities that are rising and sell them
when they are no longer in a rising trend.
A security is in a rising trend when :
It is making higher highs and higher lows on a weekly chart
Closing prices are above the 34 week moving average
The 34 week moving average is rising
The weekly chart, Chart 2, of the Australian Stock Exchange meets these criteria.

(D)

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AUSTRALIAN STOCK EXCHANGE (ASX)

CHART 2

Higher highs are at (A), (B), (C) and (D). Higher lows are at (E), (F) and (G). Prices
closed above the moving average and the moving average is rising in May, 2003, at
the arrow. This would have been a good entry level but we will assume we missed the
opportunity and are looking for subsequent entry signals.

My next step is to switch to a daily chart and look for temporary oversold
conditions in the rising security. This is done with another common indicator called
Relative Strength Indicator (RSI). RSI compares the average of rising price change to
falling price changes and I use a 7 day time period. RSI is an oscillator with a number
between 0 and 100 and I put it on the chart in an inner window, Chart 3.

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AUSTRALIAN STOCK EXCHANGE (ASX)

CHART 3

When the RSI oscillator drops to 30 it indicates the security is potentially oversold.
This occurred on three occasions after the May weekly signal, being August,
November, and January with the oversold areas circled on the chart. I am now
prepared to buy shares in ASX once prices resume rising. I will always miss the
beginning of every move as I will only enter the market after the securities price
reaches the temporary oversold area and then continues with the rising trend. My
entry trigger occurs when the closing price has moved the distance from the recent
low equivalent to two times the average true range of the last ten days. I have
programmed my software package to paint the bars blue once this criteria is met and
red bars when the closing price has moved the distance from the recent high
equivalent to two times the average true range of the last ten days. The formulas are:
C>(LLV(L,20) + 2*ATR(10))
In English this formula says:
Close greater than the Lowest Low Value (Based on the low of the last 20
days) plus 2 times the ten day ATR.

C<(HHV(H,20)+2*ATR(10))
In English this formula says:
Close less than the Highest High Value (Based on the high of the last 20
days) plus 2 times the ten day ATR.
See below for entering all formulas into MetaStock.

Chart 4 shows the RSI oversold areas and the corresponding blue bar Volatility
Entry levels (arrows).

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AUSTRALIAN STOCK EXCHANGE (ASX)

CHART 4

My initial stop is just under the recent low but once prices continue to rise I use a
Volatility Trailing Stop. I exit the position after two consecutive closes below trailing
stop. The stop is two times the ATR subtracted from the close. The formula is C2*ATR(10). This indicator rises and falls with the level of volatility and higher or
lower closing prices. I never want to lower the trailing stop so adjust the formula to
stay at the highest level reached for a period of 15 days or weeks, depending on the
chart time frame. The formula for this is: HHV(C-2*ATR(10),15).
Chart 5 is a weekly chart of the ASX showing the Volatility Trailing Stop.

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AUSTRALIAN STOCK EXCHANGE (ASX)

CHART 5
Any positions taken on our entry signals would still be active as the trailing stop has
not been breached. Shorter term traders will want to use the Volatility Trailing stop on
a daily chart to signal quicker exits. This is shown in Chart 6.

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h VOLATILITY
TRAILING
STOP

DAILY CHART
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AUSTRALIAN STOCK EXCHANGE (ASX)

CHART 6

When I use daily charts for shorter term trading I also use an indicator to signal when
the security has moved too far too fast and has created a profit taking opportunity. The
formula combines a moving average of the highs with ATR volatility. The formula is:
Mov(H,13,E) + 2*ATR(10). A clear close above the JB Profit Taker signals the profit
taking opportunity and the position is exited on the following opening price. Chart 7 is
a daily chart of the Western Mining Resources (WMR) showing the trailing stop
signals and the profit taking opportunity.

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JB VOLATILITY
PROFIT TAKER

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h (B)
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(A)

VOLATILITY
TRAILING
STOP

VOLATILITY ENTRY
INITIAL STOP

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AUSTRALIAN STOCK EXCHANGE (ASX)

CHART 7

The RSI(7) reached oversold levels at point (A). A Volatility Entry signal occurred on
the 27th November at point (B). Shares would be purchased on the open the following
day at $4.76. The initial stop is below the recent low at $4.39. A profit taking
opportunity occurs on January 6th when there is a closing price clearly above the JB
Profit Taker at point (C). The position would be closed on the following days open at
$5.71 at point (D). Two consecutive closes below the Volatility Trailing Stop signals
an exit three days later at point (E).
Where to enter and exit a trade are vitally important components of a successful
trading system. Beginning investors often struggle with developing a disciplined and
consistent strategy. Volatility can help investors set specific entries, trailing stops and
profit taking opportunities. Choosing these points at random, on what the investor
thinks at that moment is fraught with danger. Beginning investors might believe they
are using common sense when they are more likely trading what they feel. If you
trade what you feel you will lose your money as your emotions will rise and fall with
the value of your trading positions. Fear, greed and denial are not the investment tools
we want to use in a disciplined investment strategy. Volatility entries and exits help
maintain the discipline necessary to become a successful investor.

VOLATILITY ENTRY ADVISOR

C>(LLV(L,20)+2*ATR(10))

C<(HHV(H,20)+2*ATR(10))
TOOLS, EXPERT ADVISOR, NEW, ENTER NAME, HIGHLIGHTS, NEW,
NAME(BUY), TYPE IN CONDITION(FORMULA),OK, NEW, COLOR(RED),
NAME(SELL), TYPE IN CONDITION(FORMULA), OK
TO APPLY TO CHART: TOOLS, HIGHLIGHT ADVISOR, ATTACH, OK

VOLATILITY TRAILING STOP INDICATOR

C-2*ATR(10)
TOOLS, INDICATOR BUILDER, NEW, ENTER NAME, TYPE IN
FORMULA, OK
TO APPLY TO CHART: CHOOSE FROM QUICK LIST, DRAG AND DROP
OVER CHART

TRAILING STOP P15

HHV(P,15)
THE VOLATILITY TRAILING STOP INDICATOR(ABOVE) OFTEN HAS
FALLING VALUES AND WE MIGHT NOT WANT TO LOWER OUR STOP.
THE TRAILING STOP P15 INDICATOR WILL MAINTAIN THE STOP AT
THE HIGHEST VALUE OVER THE PAST 15 DAYS.
TOOLS, INDICATOR BUILDER, NEW, ENTER NAME, ENTER HHV(P,15)
IN FORMULA WINDOW, OK
TO APPLY TO CHART: CHOOSE FROM QUICK LIST, DRAG AND DROP
OVER VOLATILITY TRAILING STOP INDICATOR LINE
Combine ATR stop with P15:
HHV(C - 2*ATR(10),15)

VOLATILITY PROFIT INDICATOR

Mov(H,13,E)+2*ATR(10)
TOOLS, INDICATOR BUILDER, NEW, ENTER NAME, TYPE IN
FORMULA, OK
TO APPLY TO CHART: CHOOSE FROM QUICK LIST, DRAG AND DROP
OVER CHART