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Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.
SYSTEM DESIGN

The Volatility TRUE RANGE

The volatility stop system assumes that an asset’s future
volatility will most likely be correlated with its recent past

Stop System volatility. There are many ways to define volatility, but
perhaps the simplest is by measuring the swing of an asset
from highest high to lowest low over a given period — that
is, you measure the price range. The only wrinkle here is that
prices can gap up or down and not fill the gap. To handle
these gaps, first you check to see whether gaps have
occurred and correct for it. The resulting indicator is the true
range.
To use an example, let’s say that our stock with a 20-100
price range closed on Monday at 100, then released miser-
Here’s a step-by-step through the development of a able earnings after the closing bell. If the stock opened on
robust trading system for capturing major market Tuesday at 50, which turns out to be the daily high, then
moves. closes at 40, the stock’s daily range is only 10 points (50-40),
but its true range is 60 (the true high of 100 minus the true
low of 40). In this case, the stock’s daily range would grossly
olatility systems have a long understate its volatility.

V
Mathematically, the true high is defined as the greater of
and honored history in techni- this bar’s high and yesterday’s close. The only time that
cal trading. Here, I’ll show you yesterday’s close would be greater is if the stock gapped
a simple, robust version you down, in which case measuring the distance from yesterday’s
close to today’s low would be more meaningful and more
can use on a weekly basis. I representative of the stock’s price swing than measuring the
include code in a sidebar and difference between the intraday high and low. Similarly, the
true low is defined as the lesser of today’s low and yesterday’s
show the results of optimizing close. It follows that the true range is the greatest difference
the system for the Dow Jones Industrial Average between
(DJIA), some stocks, and some mutual funds. The
1 Today’s high and today’s low, or
results are good across the board. 2 Today’s high and yesterday’s close, or
The most robust systems adapt themselves to the 3 Today’s low and yesterday’s close.
market or security being traded. One indicator par- The average true range just averages the values for each
ticularly well suited to the intermediate-term trader bar for the number you choose, which can be any period.
or investor is what I refer to as the volatility stop. The Using a four-bar averaging period would average the true
range of each bar over the last four bars.
volatility stop is based on the idea that a trading stop Considered graphically, the average true range, in most
should be adjusted for an asset’s volatility, here cases, equals the average height of each bar in a bar graph
over the averaging period.
measured as the average true range. (For more on
By using this measure of volatility, the volatility stop
true range, see the sidebar.) system is responsive to the behavior of the trading asset. —
M.V.
THE VOLATILITY STOP
If I’m going long, the volatility stop is constructed by the system. Mathematically, the volatility stop is
starting with the entry bar’s close and subtracting a expressed as:
multiple of average true range. I use a four-week
averaging period and vary the number of multiples of Volatility_Stop =
average true range to subtract when I’m optimizing Close - (average true range of past four weeks) (# true ranges to
subtract from the close)

The greater the number of true ranges, the wider

your stop, and the more willing you are to let prices
swing before declaring a change in trend.
by Mark Vakkur, M.D. An additional necessary modification is that the
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.

volatility stop cannot go down, only

up or sideways, unless penetrated by
the bar’s low. For details, see sidebar
“Programming and plotting in
TradeStation,” in which I show the
results of optimizing the system for
the Dow Jones Industrial Average
(DJIA), some stocks, and some mu-
tual funds.
If you are going short, construct a
volatility buy-stop using a multiple
of average true ranges above the
close. Simply add to the close the
product of average true range multi-
plied by the number of ranges. This
indicator must not go up unless pen-
etrated by the last bar’s high, at
which point you’d be stopped out.
Here, however, I will only use the
volatility sell-stop, weekly bars,
and a four-week lookback period.
The same principles apply in any
time frame.

THE SYSTEM
I combine the volatility sell-stop
with a simple breakout buy-stop and
a moving average filter, long only.
The entry is: if this week’s close is
greater than the 12-week exponen-
tial moving average of the closes,
then buy at this week’s high plus
one tick on a stop. The moving
average filter is a crude screen of
intermediate- to long-term trend to
avoid entering the market during a
sustained downtrend.
Exit the long position at the vola-
tility stop on a stop. And that’s it.
The system is designed to catch
any trends and eventually get out
on a stop that constantly adjusts for
the actual volatility of the trading
vehicle.

THE DJIA
Next, I tested the system on histori-
cal data. The D JIA is a moderately
trendworthy market and has been
particularly since 1982, when it
broke out of a trading range that it
had entered back in 1968. If my
system is any good at identifying
BRAD WALKER

and catching trends, it should do

just that with the DJIA .
To apply the system, I ran an opti-

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.

mization varying the number of average true ranges to subtract

APPLICATION OF THE VOLATILITY STOP SYSTEM
from the close from 0.50 to 2.50 by increments of 0.5. I
TO THE DJIA, FEBRUARY 1988 TO DECEMBER 1998
anticipated that the lower the average true range factor (the lower
ATR Net Profit n % Profit
the number of average true ranges required to generate the sell multiplier profit factor per trade
stop), the higher the number of trades, with many trades stopping 0.50 2153 1.58 98* 42 21.97
out for a small loss. As it turned out, this assumption was correct, 1.00 2455 1.73 64 47 38.37
as Figure 1 shows. 1.50 4082 3.60 34 47 120.06
2.00 3555 2.80 25 44 142.21
2.50 4603* 6.08* 16 63* 287.70*
The volatility stop system offers ATR multiplier = The multiple of average true ranges that must be
penetrated to declare the end of an uptrend
an excellent means of defining and n = Number of trades
capturing major market moves. It Percentage = Percent profitable
Profit/trade = Average profit per trade, winners and losers, ignoring
appears robust across an array of slippage, commissions dividends and interest earned while in cash
assets and multiplier values. * = Greatest value in each column.
FIGURE 1: To apply the system, Vakkur ran an optimization varying
the number of average true ranges to subtract from the close from
The system is profitable across all parameter values, indicat- 0.50 to 2.50 by increments of 0.5. He anticipated that the lower the
ing that our idea may be robust. Second, the profitability was average true range factor (the lower the number of average true
ranges required to generate the sell stop), the higher the number of
relatively stable, showing an overall trend toward greater trades, with many trades stopping out for a small loss. As it turned
profitability as the value of the average true range (ATR) factor out, this assumption was correct, as Figure 1 shows.
was increased. Third, the smaller the ATR multiplier, the
greater the number of trades and the less average profit per
trade. Finally, the profit factor (the ratio of gross profit to gross COMPARISON OF TRADING SYSTEM RESULTS
loss) also increases as we increase the ATR factor. System Net Profit n % Profit
Whenever we think we have a good system, we should ask profit factor per trade
ourselves, “Compared to what?” A poor man’s test for compa- Channel brkout $2713 2.01 50 38 $54
rability to buy and hold is to subtract the price of the asset at the MACD $4232 12.25 17 71 $249
end of the period from the price at the beginning of the period Volatility stop $4603* 6.08* 16 63* $288
and compare it to the total number of points earned by the FIGURE 2: The rules for the MACD are more complex. If the 12-week/26-
week exponential moving average MACD is greater than its six-week
system. In this example, the best case of 4,603 does not
exponential moving average, then buy at this week’s high stop. If long, place
compare favorably with the 7,100-point gain of the DJIA during a sell-stop at this week’s low if the MACD drops below its six-week EMA. For
that period. all of the systems, long and flat were the only possible positions. The results
However, this was a historically aberrant period for the DJIA, can be seen here.
so comparisons to buy and hold during this period would be
tough to beat. In addition, though not shown, this 4,603-point
gain was made with substantially less risk than buy and hold.
For comparison to another trading system, I compared the
volatility stop system with the simple channel breakout system
I presented in my April 1999 STOCKS & COMMODITIES article.
The rules for channel breakout are simple: If this week’s close
is greater than the 12-week exponential moving average (EMA),
then buy-stop at this week’s high and exit long at the trailing
three-week low on a stop.
The rules for the moving average convergence/divergence
(MACD) are more complex. If the 12-week/26-week exponen-
tial moving average MACD is greater than its six-week expo-
nential moving average, then buy at this week’s high stop. If
long, place a sell-stop at this week’s low if the MACD drops
below its six-week EMA. For all of the systems, long and flat
were the only possible positions. The results can be seen in
Figure 2.
Not only is the volatility stop system more profitable than the
channel breakout system for ATR factors greater than 1, but it FIGURE 3: BEST BUY. Best Buy has had dramatic ascents followed by brutal selloffs.
requires far fewer trades (from 34 to 16 compared with 50 for
the channel breakout system) to capture the profits. The result
of the MACD system is comparable to the profit of the volatility

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.

stop system between 2 and 2.5 ATR factors.

Satisfied with the DJIA results, next I tested the system on PROGRAMMING AND PLOTTING IN TRADESTATION
stocks and mutual funds. You can plot the volatility stop easily in TradeStation. You
should offset the indicator by a week, using the last bar’s
close to generate this week’s bar’s plot, since the value of
this week’s close won’t be known until the end of the week.
For plotting purposes, I’ve added a conditional check to
BEST BUY determine if price penetrated the indicator, and if not, then to
Best Buy (Figure 3) has had dra- ensure that the calculated value for this bar’s sell-stop is not
matic ascents followed by brutal less than the previous value of the volatility sell-stop. Here
selloffs. If a trend-following sys- is the TradeStation EasyLanguage for when you are only
tem cannot make money with Best long stock:
Buy, then we should question the
ability of the system to identify Indicator name: Volatility_stop
and exploit trends. Inputs: ATR_len(4), ATR_fac(2)
Volatility_Stop = MaxList ( c[1] -
So how did the volatility stop
AvgTrueRange(ATR_len)*ATR_fac, iff(l[1] < plot1[1], 0,
system perform with Best Buy? plot1[1]))
As it turns out, quite well (Figure
4) from January 1990 to November 1998. Profits peak with Where:
stops around 2.5 times average true range, then drop off ATR_len = number of bars to use for averaging of
sharply as we increase beyond 3. As it turned out, 2.5 was also the true range, initially set to 4
the optimal number for total profit, profit factor, percent of ATR_fac = the multiple of average true ranges to
trades profitable, and average profit per trade. Just as with the add or subtract from the close, initially set to 2.
DJIA, the smaller the multiplier, the more trades generated,
Working from inside out, the indicator first checks if the last
and the less profit per trade. The results of the channel bar’s low penetrated (was less than) last bar’s value of the
breakout and MACD systems on Best Buy for the same period volatility stop, in which case the indicator by default would be
can be seen in Figure 4. assigned the calculated value, c[1] (last bar’s close) minus
The tradeoff here is between total profit and efficiency in the product average true range times the average true range
terms of number of trades and profit per trade. This is impor- factor (ATR_fac). (This occurs since a zero would be re-
tant, since commissions and slippage — ignored here — would turned, which when compared to the computed value would
take a much bigger toll on the channel breakout system than on be less, so the function MaxList would return the calculated
the volatility stop system. The MACD system seems to be less value.) If the last bar’s low did not penetrate the volatility
stop, then the last bar’s volatility stop is returned (plot1[1]),
effective in all respects except percent profitability.
which is then compared to the computed value; the maxi-
mum of the two (MaxList) is assigned to the indicator.
50 9 The EasyLanguage formula for the short version is:
45 8
Volatility Stop System Indicator name: c_plus_vol:
40
Best Buy 7
35
Indicator formula: MinList ( c[1] +
PROFIT FACTOR

6
30 AvgTrueRange(ATR_len)*ATR_fac,iff(h[1] > plot1[1], c*2,
NET PROFIT

25 5 plot1[1]))
20 4
This should look familiar with one modification; the only
15
3 difference is that you use the last bar’s high and are now
10 interested in knowing if it is greater than last bar’s volatility
2
5 buy stop (h[1] > plot1[1]). If so, use the calculated value:
0
1 average true range times the average true range factor
(ATR_fac) plus the close. Use this value, since the indicator
-5 0
0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10 will use the minimum (MinList) of the calculated value and
AVERAGE TRUE RANGE MULTIPLIER double the close, which will be greater than the calculated
value, so will be discarded.
System Net Profit n % Profit On the other hand, if last week’s high is not greater than
profit factor per trade the last week’s volatility buy-stop, then last week’s volatility
Channel breakout 50.95 6.15 25 56 2.04 buy-stop (plot1[1]) is compared to the calculated value to
MACD 26.69 3.87 14 64 1.91 determine which is less. This will prevent the indicator from
Volatility stop 42.87 7.64 12 58 3.57 going down unless penetrated by last bar’s high. —M.V.
FIGURE 4: BEST BUY. Trending behavior is captured in the volatility stop
system, here shown with both buy-stops (red) and sell-stops (blue). Neither form
of stop is ever relaxed once started.

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.

So far, it appears that the volatility stop system in the 2-3 60 7

multiplier range gives solid results. This is reassuring, since

the DJIA and Best Buy behave quite differently. This illus- 50 Micron Technology 6

trates the advantage of a system that inherently adapts itself 40 5

to different assets and market conditions, since it is the

PROFIT FACTOR
NET PROFIT
multiple of a measure of the volatility of the asset and not 30 4
some arbitrary value.
Looking for another stock that has demonstrated well- 20 3

defined uptrends and downtrends turned up Micron Technol-

10 2
ogy [MU], which is both volatile and cyclical. Results are
summarized in Figure 5. Once again, the system is profitable 0 1
across a range of multipliers, which should reassure us that the
premise of our trading system is robust. -10 0
0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5 9 9.5 10
Once again, the 2-3 range is profitable. The volatility stop AVERAGE TRUE RANGE MULTIPLIER
system with values of 2-3 ATM factors offers a nice balance
between how much movement is significant and how much FIGURE 5: OPTIMIZATION. Optimizing the volatility stop system on the DJIA
showed that an ATR multiplier of 2.5 worked best, though there was a broad
money the investor is willing to lose by being stopped out.
range of profitability.
For comparison purposes, I checked the other two systems
on Micron, as can be seen in Figure 6.
Although the channel breakout system manages to capture
MICRON TECHNOLOGY
more net profits, its profitability per trade is less than the
System Net Profit n % Profit
volatility system. It took 51 trades to capture the profits that the profit factor per trade
volatility stop system, with a multiplier of 3, caught in 15 trades.
Channel brkout 71.17 3.75 51 51 1.40
After taking commissions and slippage into account, which this MACD 17.89 1.42 30 37 0.60
testing did not, as well as psychological wear and tear, the Volatility stop* 47.81 5.82 15 60 2.14
volatility stop system would most likely be more effective. *Average true range multiplier = 3
FIGURE 6: Compared to the DJIA, a slightly higher value of the ATR multiplier,
FIDELITY SELECT ELECTRONICS 3.0, works well for Micron Technology.
I finished by applying the system to two mutual funds, Fidelity
Select Electronics and Fidelity Select Home Finance. Again, if
one’s trading system is robust, it should not matter whether it 30 8
is applied to soybeans or Microsoft, stocks or mutual funds. By
7
their nature, mutual funds differ from individual stocks only in 25 Volatility Breakout
that their moves tend to be less volatile, since their volatility FSEAX
6
represents the aggregate volatility of the individual assets in the

PROFIT FACTOR
20
NET PROFIT

5
portfolio. In other words, the behavior of mutual funds re-
sembles that of an index. 15 4
The major disadvantage of trading mutual funds is that stop-
3
loss orders cannot be entered mechanically; you must monitor 10
the assets yourself and only exit the day after a sell signal, 2
unless you successfully anticipate a close below a given level, 5
1
which is possible if you know the performance of an index or
basket of stocks with which the mutual funds is highly corre- 0 0
0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5
lated, and in most cases you cannot exit intraday. (The Select AVERAGE TRUE RANGE MULTIPLIER
funds offered by Fidelity are an exception to the latter disad-
vantage, allowing hourly pricing and trading.)
Repeating the process and comparing the results of the three FIDELITY SELECT ELECTRONICS
systems I have been using for Fidelity Select Electronics gives System Net Profit n % Profit
us the results of Figure 7. profit factor per trade
The volatility system is superior in all counts except for MACD 15.45 2.21 13 46 1.19
percentage profitability (all systems are comparable in this Channel brkout 23.03 3.68 29 52* 0.79
Volatility stop* 24.98* 7.31* 16 50 1.56*
regard). It is not only more profitable, but it is so with fewer
*Average true range multiplier = 2
trades, leading to a higher profit per trade. (The multiplier of 2
was arbitrarily chosen, not optimized.) In addition, Figure 7 FIGURE 7: FIDELITY SELECT ELECTRONICS. ATR multipliers from 2 to 3 work
well again when tested on FSEAX. Values above 6.5 produced no losses and
shows that the volatility stop system remains stable across therefore aren’t comparable.
different values of the ATR multiplier.

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V17:10 (427-432): The Volatility Stop System by Mark Vakkur, M.D.

46 18
SUMMARY
The volatility stop system offers an excellent means of defining
16 and capturing major market moves. It appears robust across an
44
14 array of assets and multiplier values. It is intuitively appealing
because it adjusts itself to different markets and assets. It

PROFIT FACTOR
42 12
usually generates fewer trades than the simple channel breakout
NET PROFIT

10 but generally seems to have comparable profitability, resulting

40
8 in a much higher average profit per trade.
In a real-world situation where psychology, commissions,
38 6
and slippage take their toll, the volatility stop system is prob-
Volatility Stop System 4 ably superior to a channel breakout system. In most cases, the
36
FS Home Finance 2 MACD system tended not to capture as much profit as the
volatility stop system. Of the three, the MACD is the most
34 0
0.5 1 1.5 2 2.5 3 3.5 4 4.5 abstract indicator, since it is a derivative of a derivative of
AVERAGE TRUE RANGE MULTIPLIER price; the more profitable breakout systems are based more
directly on price itself. Once again, this underscores the adage
FIDELITY SELECT HOME FINANCE of Keep it simple!
System Net Profit n % Profit
profit factor per trade Mark Vakkur is a psychiatrist and a stock trader.
Channel brkout 34.97 4.27 34 65 1.03
MACD 34.05 15.55 14 79 2.43 RELATED READING
Volatility stop 36.86* 5.86 23 78 1.60 Aan, Peter [1989]. “Volatility System,” Technical Analysis of
*Average true range multiplier = 2 STOCKS & COMMODITIES, Volume 7: July.
FIGURE 8: ATR multipliers in the range of 3.5 to 4.0 are somewhat higher for this Vakkur, Mark [1999]. “Channel Breakout System,” Technical
sector fund, indicating the volatility stop is sensitive to the tradable’s behavior. Analysis of STOCKS & COMMODITIES, Volume 17: April.

†See Traders’ Glossary for definition S&C

FIDELITY SELECT HOME FINANCE

The final asset to which I would like to apply the volatility stop
system is Fidelity Select Home Finance. This security is not
well correlated with the technology sector (as the other assets
are), but represents an interest rate–sensitive collection of
financial stocks. Figure 8 shows how the volatility stop system
performed.
Once again, the volatility stop system is superior in terms of
net profitability and profit/trade compared with the channel
breakout system. The MACD system, however, appears supe-
rior to the others in terms of profit factor and profit per trade;
however, it does not capture as much total profit. See Figure 8
for a somewhat higher peaking of the profit factor than in
previous tests (at 3.5), although the 2-3 ATR multiplier area is
respectably profitable.

Copyright (c) Technical Analysis Inc.

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