Volatility Is Your Friend

Traders have been knocked around markets by the increased volatility in 2008 and 2009. Index moves of between 2 to 3 percent used to be rare, but are the norm in today’s environment. These kinds of margins play havoc with stop-loss settings.

It’s fair to say that we’ve been whipsawed in and out of stocks by short-term volatility, even though the underlying trend is consistently moving in a single direction. And the result seems to be a loosening of stops to counter the extra volatility. It sounds perfectly logical, but it also increases the risk in a trade.

Part of the problem, comes from the way we defined trend behavior before 2008.

We’ve become lazy. Traders assumed that price volatility is the same as trend volatility. In the past, trend management tools were based on measuring price volatility. But things changed in 2008.

Traditionally most traders see volatility as an enemy. The solution is to shift our understanding of trend volatility. Traders can then use volatility as a friend.

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The first in realizing this change is the concept of the momentum minute. The objective is to use acceleration in volatility to determine the entry point in the trade. This acceleration quickly carries the trade into a winning environment and lifts the stop-loss level. Traders can then use a breakeven calculation as the stop-loss point.

The second application is to use the Guppy Multiple Moving Average, to calculate a trend volatility line. This is used as a stop-loss management tool in a profitable trade. It uses the volatility of the trend to set the stop loss. This is a calculation based on duration and amplitude of trending behavior. It sounds complex, but the end result is a series of lines plotted under the rising trend. The stop loss is directly related to the changes in trend volatility.

This management method is applied to intra-day charts and then transferred to longer intra-day time frames, and eventually to end of day charts. It allows for long-term management of the developing trend and maximizes profits while minimizing false exits.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.

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