Trading Basics—Average True Range—Part Two

09/25/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Trading Basics – Average True Range – Part Two

In the first part of this article, we looked at how the Average True Range (ATR) could be used to determine position size based on volatility and to determine a trailing stop. This formula for stops on long positions called ATRLS, looks at the highest high over the past 20 periods and then subtracts three times the 14-period ATR to calculate the stop. For additional smoothing, we also compared this value with using a 20-period MA of the highest high value. On the short side, the ATRSS, takes the lowest low of the past 20 days (or its MA) then adds three times the ATR (14) to this value. In part one, we looked at how these stop formulas worked on the long side, and in the second part, we will look at how it works on the short side.

Figure 1

Once again, we will look at the SPY as it is one of the most liquid and popular ETF and option trading vehicles. The chart begins in November 2007, and after a sharp decline into the end of the month, the SPY traced out a continuation pattern, lines a and b. Though the daily momentum turned lower just after Christmas, the support at line b was not broken until the first trading day of 2008 (point 1). The close was at 144.83 with the ATRSS at 150.66 and the previous swing high was at 149.68. The ATRSS worked fairly well over the next few days as the SPY plunged to a low of 126 on January 22nd. The stop at 136.03 was hit three days later as the rally off the lows was extremely powerful. The SPY traced out a flag formation over the next four weeks, lines c and d, which was completed on February 29th (point 2). The test of the January lows was successful and the ATRSS was hit ten days after the lows for a slight loss. The SPY then traced out another continuation pattern over the next two months, lines e and f, which was completed on May 21st with a close at 139.49. At this point the ATRSS was at 143.72, and the SPY opened the next day at 139.43 so the stop was just over 3% above the entry. The SPY did rebound over the next week to 140.94, which decreased the risk significantly (point 4). The doji formation also set up a good sell signal. The ATRSS performed well during the decline into the mid-July lows at 120 as the stop was eventually hit on July 22nd.

Figure 2

Let’s now look at the same time period comparing the ATRSS (in green) with the smoothed version ATRSSma (in red) where a 20-day moving average of the lowest low of the past 20 days was used. The bottom line is that while the smoothed visually appears to be superior during this time period, in reality there are few differences. For example, in the rally off the January lows, the ATRSS was hit at 136.03 while the ATRSSma was hit at 136.93 (point 2). On the rally from the March lows, the smoothed stop loss was hit a few days later that the ATRSS and at approximately 1.5 points higher. The exit levels after the July lows were approximately the same and they occurred a week apart.

Figure 3

Cleary, these samples seem to be inconclusive as to whether the regular or smoothed ATR based stop works better. The most important criteria in my mind for a stop are to have one that will keep you in a trade for an intermediate up or downtrend. Nothing is more frustrating from a trading or investing standpoint than to spend the time and energy to analyze a market correctly but then either not get on board the trade or to get taken out very early in the trend. One of the most significant downtrends in the last ten years occurred in the NASDAQ during 2000 to 2003. The daily chart above covers the period from June 2000 through November 2001 and also has the ATRSS and ATRSSma. The QQQQ broke support in mid-September 2000, point 1, at $89.09. QQQQ stayed below both stops until December 11th when the ATRSS was hit on the bounce to the $74 area (circle a). Prices stayed below the ATRSSma and three weeks later, QQQQ closed just above $52. The QQQQ rebounded impressively over the next three weeks, exceeding the $64 level (circle b) and hitting both stops. Two weeks later, the QQQQ broke again to the downside and reached the $33-34 level in April. If one was short going into these lows both stops were hit near the same price (circle c). After a four-week rally, the QQQQ again broke support, completing another continuation pattern. Both stops held for the ensuing five-month decline into the middle of October, as shorts would have been stopped out either at $31.80 (ATRSS) or at 32.90 (ATRSSma).

Figure 4

Another sector that has been in a strong downtrend recently, has been the homebuilders as represented by the S&P Homebuilders (XHB). The XHB was moving lower in early 2007 but then rebounded briefly in April and both stops were hit at close to the same level. After a typical eight-week rebound and the formation of a continuation pattern (lines a and b), support was broken, point 1, as XHB closed at $34.25. It then declined for the next two months reaching a low of $24.40 on August 6th. The 18.4% rebound from the lows hit the ATRSS, point 2, but not the ATRSSma. By September 10th, XHB traded in a tight range for several days in the $22.60-23.00 area (point 3). This preceded another sharp rally on September 19th, which hit both stops. After clearing out some shorts the downtrend resumed and prices held below the ATRSSma until December 12th, point 4. The ATRSS was hit several times in October (blue arrows) while prices stayed below the ATRSSma.

These last two examples suggest that the smoothed version (ATRSSma) works fairly well and is superior to the ATRSS. On the bottom of Figure 3, I have also plotted the RSI3, which is one of my short-term momentum indicators. As I have discussed in previous articles, I prefer taking profits at price targets or at what I determine to be price extremes. The RSI3 is a useful tool in this process as when it drops to the 15 area or above 85 (dashed lines) it often precedes a rebound or a pullback, though not a change in the major trend. In the example above, the RSI3 dropped below 15 at both the November 2007 and January 2008 lows (see circles). Sometimes, the RSI3 will form a double bottom or top formation before a strong move against the major trend.

I hope that these articles on the ATR will stimulate your interest and that you may decide to incorporate the ATR into your trading plan. I am looking at a couple of additional ways to use the ATR which includes using the ATR with the ADX to identify trending and non-trending markets and additionally using the behavior of the RSI3 to adjust the ATR stop methods discussed in this article. Stay tuned.

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