Volatility
Up to this point, we’re operating with a $50,000 account, which we have divided up into 10 individual positions. In each of these positions, we’re willing to risk 2 percent of the account equity, or $1,000 per position. This is the part of the system that is within your control.
The part of the system that is out of your control is the market and what’s happening in it right now. Be realistic, the market doesn’t know you and doesn’t care about you. The market is ignorant of who you are and how much you’re willing to risk. The market doesn’t care how much money you have in your account. The market is going to do what it’s going to do independent of you. It is your responsibility, therefore, to understand what’s happening in the market right now and how it relates to your risk management and stop placement.
All markets – stocks, bonds, currencies, futures, commodities – go through cycles of volatility. Sometimes they move a lot, whipping back and forth from day to day. Other times they steadily trend in one direction or the other without much interruption. You need to learn how to adjust the risk you’re willing to take in your own positions to what’s happening in the market.
The single best tool for measuring the market’s volatility is the Average True Range (ATR). The ATR is an indicator developed by Welles Wilder. The ATR measures the volatility of any security, ranging from stocks to commodities. The indicator forecasts nothing about the direction of the security. All the ATR looks at is the volatility of the security. That’s it.
We’re not going to go into the calculation of the ATR. If you’re really interested, you can find it on StopLossOrders.net. We’re going to focus on how to use ATR to gauge market volatility and determine an effective stop loss.
Let’s take a look at an example of the ATR in action on the S&P 500 SPDRs (SPY) – an exchange traded fund (ETF) that tracks the S&P 500. (See Figure 1.5) We’ll look at a 14 day ATR, which is the default setting you’ll find on most charting platforms.
Figure1. 5 – 14 day ATR
The ATR is usually plotted as a line as seen in Figure 5. It moves up or down as the underlying security becomes increasingly volatile or decreasingly volatile, respectively. In addition to displaying changes in volatility, the ATR gives you a general idea about how much the underlying security moves on any given day.
The ATR is denominated in points (dollars) for stocks such as the SPY. The ATR is denominated in whatever the security is denominated in such as pips in the forex market, points in futures, or basis points for interest rate products.
Note the range in Figure 5 from a low below 1.5 in June to a high near 3.5 in August. This range is roughly 1.5 points to 3.5 points, or $1.50 to $3.50.
Let’s take a look at the current value for the ATR, using the same SPY chart as an example. (See Figure 1.6)
Figure 1. 6 – Current 14 day ATR
Look in the left hand corner of the indicator pane, where the current 14 day ATR is 2.709. Rounding to the nearest cent, this means that the SPY averaged a daily move of $2.71 over the last 14 days. That’s where the ATR line is plotted on the far right edge of the indicator pane. This value will change at the end of each day as the oldest of the past 14 days is dropped and a new day is added to the 14 day average.
This value – the SPY 14 day ATR of $2.71 – is a great place to start when figuring where to place your stop. You might simply use the current value ($2.71) and subtract it from your entry price, placing your stop one ATR below the entry price.
Let’s assume you are buying the SPY at its current price of $145.85. Simply subtract $2.71 from your entry price to arrive at your stop loss of $143.14. (See Figure 1.7)
Figure 1. 7 – 14 day ATR Stop Loss
When using the ATR to determine your stop, you just might stop right here and not even consider making any modifications. Of course this set-up must fit with your overall strategy. You will have to decide if it does or not.
Whether the 14 day ATR does or doesn’t fit perfectly with your overall approach, we’re left with a problem. How much of the SPY should you buy? Furthermore, how does the $2.71 stop loss fit with your acceptable risk per position? Answering these questions will bridge the gap between your risk – the part of your system you can control – and what the market is doing – the part you cannot control.
Let’s run through an exercise to determine position size, using the set-up in the SPY. Remember you’re working with a $50,000 account with which you’re willing to risk 2 percent, or $1,000 per position. (See Table 1.8)
Risk | 14 day ATR Value | Position Size |
1000 | 2.71 | 369 |
Table 1. 8 – Position Size
The calculation in Figure 8 is rather simple: divide risk by the ATR value (1000/2.71 = 369).
Based on the system, you should buy 369 shares of SPY. But wait a minute. How much is the SPY trading for? It’s $145.85 per share. It requires $53,819 to buy 369 shares of SPY at $145.85. You only have a $50,000 account. You’re $3,819 short, plus commissions.
Even though you’re staying within your risk parameters on this one position, you’re committing a fatal error by placing your entire account in one position. You’ve just thrown diversification out the window. Remember, you want to spread your $50,000 across 10 positions, allocating $5,000 to each.