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Trailing ATR STOP

In this part we will look at the application of risk management, continuing with the use of trailing stops and here looking at the trailing ATR, or average true range stop.

A trailing stop should be used as a last warning signal to close a trade when other technical or human signals fail, that way preventing losing profit. The very last warning is of course the initial stop.

ATR or Average True Range was developed by J. Welles Wilder and introduced in his book, “New concepts in technical trading systems” (1978). The Average True Range (ATR) indicator measures a security's volatility

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Hallo, Sylvain Vervoort with technical analysis part 30. In this part we will look at the application of risk management, continuing with the use of trailing stops and here looking at the trailing ATR, or average true range stop. Remember, the best technical analysis will not be successful without good money and risk management. Pay a visit to my website at stocata dot org and buy my new book “Capturing Profit with Technical Analysis”, a complete technical analysis reference and a winning trading system.

ATR or Average True Range was developed by J. Welles Wilder and introduced in his book, “New concepts in technical trading systems” (1978). The Average True Range (ATR) indicator measures a security's volatility. Wilder started the true range concept defined as the greatest value of:

• The current High less the current Low.
• The absolute value of the current High less the previous Close.
• The absolute value of the current Low less the previous Close.

He then calculated an average of this value for creating the Average True range. Like most technical analysis programs, MetaStock® has a predefined ATR indicator. To create a trailing stop based on the ATR value, you need to calculate the maximum-allowed loss based on the ATR value multiplied by a factor.

Let's first look at the automatic switching ATR trailing stop. With this formula, that you can find at stocata.org/metastock/formulas.html, you can experiment which ATR averaging period and which multiplication factor is most appropriate. Standard I am using a 5 days average and a 3.5 multiplication factor.

Look how in this chart a 5 days average ATR, multiplied by 3.5 nicely follows the uptrend, keeping you in the trade for several months, even with a rather choppy up move.

Using the same chart and period and comparing the ATR trailing stop with a fixed 10% trailing stop, you can notice the advantage of the ATR stop in some circumstances. Here the fixed percentage stop is broken during the up move while it is not the case for the ATR stop. The ATR takes into account the volatility of the price fluctuation of the last 5 days and leaves that moment in time a bit more room for the price to react. When there is less volatility, the ATR trailing stop will move closer to the price action, leaving less room for a price reaction. The result you can see in this chart with faster closing the position with the ATR trailing stop, compared to the fixed percentage stop.

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You should of course profit from lower volatility periods to use a smaller multiplication factor as shown in this chart. The smaller ATR(5)*2.1 is moving closer to the price action, allowing faster entries and exits, without creating extra entries or exits, that way boosting the profits.

Since you are using your own trading method to find entry points based on technical analysis signals, you want to be able to use your own entry date. Because the number of input parameters in MetaStock is limited to six, it is necessary to create separate formulas for a long position or a short position. This is the formula for a long position that you can find at stocata.org/metastock/formulas.html

And this is the formula for a short position that you can find at stocata.org/metastock/formulas.html

In this chart of Salesforce Com Inc, you can see how the trailing stop nicely captures a five-impulse-wave Elliott up move. The input settings are displayed in the chart. There is an initial stop set at $18.6, the previous low point before the buying signal. The ATR trailing stop uses a 5-day average and a 3.1 multiplication factor. The position is closed when the closing price falls through the trailing stop beginning 2006.

Look here how after the formation of the Elliott top-5 wave in Salesforce.com, the downward trending corrective wave brackets (C) stays within the trailing stop until  completed. This wave is made up of a double zigzag forming a WXY wave. Entry parameters are visible in the chart. The initial stop is set at the top of the brackets (B) correction wave at $39.8. ATR average is set at 5 and the multiplication factor at 2.8. The short position is closed with a good profit when the closing price moves above the trailing stop in July.

Is it possible to trade profitable using an ATR automatic switching trailing stop? I believe you can, if taking into account a few rules.
Rule1: only use stocks that make regular bigger moves, without surprises or extreme volatility like in this sample chart.

Rule2: find out what the best fitting multiplication factor is over the last couple of years. In the example here we used a 5 days ATR average with a 2.8 multiplication factor in the period before May 2008. Use this value into the future for this stock.

Rule3: attribute a fix starting capital to this stock, for example 5% of your total portfolio value, and do not share profits or losses with other stocks. Always invest the total available cash. So you will re-invest all eventual profits, but you will have less and less capital available if this stock is going to perform badly. However if this stock is doing well, you will nicely profit from the multiplication effect.

For Black and Decker in the example here, starting may 8 2008 until January 15 2010 or less than 2 years of daily data. Trading based on the automatic switching ATR trailing stop, the result is as follows:
Only long trades, 3 winning and 3 losing with a profit of 147%
Only short trades, 4 winning trades and 1 losing trade with a profit of 77%
Trading both long and short, 7 winning trades and 4 losing trades with a profit of 340%.

This is the end of the part about using an ATR trailing stop. Next video we will have a look at my TR&NDS trailing stop method. Tell your friends about these videos and while visiting my website order my new book “Capturing Profit with Technical Analysis”, a complete technical analysis reference and a winning trading system. See you in the next video!

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