Chuck LeBeau's System Traders Club
BULLETIN Vol. 1 Number 14 Nov. 17, 1998

Using Average True Range for Exits

This is the fourth in a series of articles about using Average True Range. In our first article in Bulletin #10 we explained how ATR is calculated and gave an overview of its many uses and benefits. In Bulletin #12 we showed some specific examples of how using ATR can help to make our systems more robust. In Bulletin #13 we showed some of our favorite applications of ATR as part of our entry logic.

In this Bulletin we will show how ATR can help us achieve more accurateexits.

ATR EXIT TARGETS: Perhaps the most valuable of all application of ATR is to use it to define profit objectives. If we were to run some tests to define profit objective in terms of dollars we could probably find a particular dollar amount that produced acceptable results when reviewing historical data. Just as an example, let's assume that we run some optimizations to find the best level at which to take profits in a particular market and we find that the best number is $1250. Although this amount may produce acceptable results on a historical basis it is not always the best solution to the problem.

When the market is quiet and there is little volatility our profits are likely to fall well short of our $1250 objective. However when the market is volatile and trending strongly our potential profit might be much greater than $1250. The $1250 level is simply a not so happy medium that is usually either too large a target or too small a target.

On the other hand if we measure our profit objective in terms of ATR we have a much more robust and logical solution. Lets assume that we run our tests again looking for units of ATR instead of dollars. Assume our research shows us that our best profit objective is now expressed as 4 ATRs. In a normal market 4 ATRs might be equal to $1250, the same as our dollar denominated target. However in a quiet market 4 ATRS might only be $800. The advantage of our ATR research is that while our original $1250 target is no longer obtainable because of the quiet market conditions the ATR target has adapted to the change in volatility and can still be achieved.

Increases in volatility produce an even more dramatic effect. Let's assume that the market is suddenly streaking in one direction because of some important news. Our 4 ATRs is now $5,000. Wouldn’t it be a shame if our system was taking profits of $1250 when the market is willing to give us $5,000 or more.

In addition to setting profit objectives, ATR can also be very helpful in placing trailing stops. Here are two examples that you may recall from discussions on the FORUM page and past BULLETINS.

THE CHANDELIER EXIT: We have often advocated the importance of good exits and this is one of our favorites. The exit stop is placed at a multiple of average true ranges from the highest high or highest close since the entry of the trade. As the highs get higher the stop moves up but it never moves downward.

Examples:

Exit at the highest high since entry minus 3 ATR on a stop.

Exit at the highest close since entry minus 2.5 ATR on a stop.

Application: We like the Chandelier Exit as one of our exits for trend following systems. (The name is derived from the fact that the exit is hung downward from the ceiling of a market.)

This exit is extremely effective at letting profits run in the direction of a trend while still offering some protection against a major reversal in trend. In fact our research has shown that this exit is so effective that you can enter futures markets at random and if you use this exit the results over time will be profitable. (If you don't believe us just try it.) When used for long term trend following the best values for the ATR in most markets ranges somewhere between 2.5 and 4.0.

THE YO YO EXIT: This exit is very similar to the Chandelier Exit except that the ATR stop is always pegged to the most recent close instead of the highest high. Since the closes move higher and lower, the stop also moves up and down (hence the Yo Yo name). Although this stop appears similar to the Chandelier Exit the logic is quite a bit different. The Yo Yo Exit is a classic volatility stop that is intended to recognize an abnormal adverse price fluctuation that occurs in one day. This abnormal volatility is often the result of a news event or some important technical reversal that is likely to signal the end of a trend. This logic makes the YO YO exit very effective and we seldom regret being stopped out whenever this exit is triggered.

We should caution you that the Yo Yo stop should never be our only loss protection because if the price moves slowly against our position the Yo Yo stop also moves away each day and, in theory, the stop may never be hit.

Combining the exits: The Yo Yo and the Chandelier exits work best when used together. The Chandelier Exit is typically set at 3 ATRs or more from a high point and never lowered; therefore it will protect us against any gradual reversal of trend. The Yo Yo exit is typically set at only 1.5 to 2.0 ATRs from the most recent close and will protect our position from unusual one day spikes in volatility. When used together the operative stop each day would be whichever of the two stops is closest.

Money Management Advice: When using any stops based on multiples of ATR we should keep in mind that volatility can quickly expand to where our risk is greater than we intended. We do not want to unknowingly exceed the risk limitations dictated by our money management scheme so we should also have a "worst case" dollar based stop available or be prepared to reduce our position size quickly as the ATR values expand. When should we reduce our position size and when should we implement our fixed dollar stop?

If we are on the right side of the volatility expansion it may not be wise to reduce our position size just as the trade is beginning to do what we hoped for. For this reason I prefer to implement the dollar based stop on profitable positions rather than reducing the size of winning positions prematurely. We obviously want to have big positions in our winners and small positions in our losers. Therefore it would make sense to reduce our position size only if the volatility is increasing in a trade that is going against us. Once extremely large profits have been achieved, positions can safely be reduced without sacrificing too much in the way of potential profits.

By now we hope you have begun to appreciate the value of ATR in designing systems. There are still more uses for ATR that we have yet to discuss (Keltner Bands for example). We hope to have additional articles about ATR sometime in the future. In the meantime we hope this series of articles has stimulated some creative thinking about the many uses of ATR. Lets us know if you come up with more creative ideas on how to apply this wonderful technical tool.

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I’ll be seeing many of you at the TAG conference in Las Vegas this weekend.

Be sure to say hello.

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Thanks again to everyone for the enthusiastic messages and referrals. Most of our new members come from referrals by members who recommend the Club to their friends and associates. We sincerely appreciate your support in making the Club grow.

Be sure to check out the new FORUM page Dave Elden has been working on.

We have a new FORUM which we will be integrating into the website very soon. It is much more configurable and user friendly than the one we have been using and it is something that we can grow with. We are not deleting any of the posts from the original Forum. We are hoping to move a few selected posts out of the old forum and into the new one and eventually develope an archive for the old posts. This will take some time, so please continue your discussions on the new FORUM when it comes online. We thank you for your patience while we are making these changes. We had no idea that the FORUM would be so popular and we are trying to make positive changes to keep up with the expanding traffic.

Lets try to promote the idea of members helping members. I think we will all benefit. Don’t be afraid to ask questions or post topics that will stimulate discussions.

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NEW SYSTEM: We should be announcing the availability of a very interesting new system in the next day or two. As soon as everything is ready we will send out an e-mail and have the usual information posted on the web site.

In the meantime please review the discussion of ADX in Bulletin #5. The new system is the result of our research on solving the "V" pattern limitations of ADX discussed in that Bulletin. We think we have made a technical breakthrough with this new system which solves a problem that has been nagging us for years. We are excited and we think you will be too when you see the results of the system.

That’s all for now.

Good luck and good trading

Chuck