Saturday, March 21, 2015

Using volatility to identify good risk:reward setups

While my primary focus is on price and its trends, I also look at volatility measurements, together with potential risks and rewards as part of my trade selection criteria.

My ideal setups show a contraction in volatility prior to price breaking out to new highs or lows. This means that potentially I can increase my position size by having  a tighter initial stop, as this is determined by the 2ATR measurement.

Then, hopefully as price starts to move in my favour, there will be an expansion in volatility.

What I don't want to do is take positions where there has already been an expansion in volatility before the entry is triggered. This has an adverse effect on the potential risk:reward measurement. If the 2ATR reading increases, then I have to take a smaller position size, with my initial stop further away from the desired entry level. This then means the price has to move further before your profits start to get to 1R or above (i.e. to make at least as much as your initial risk).

Trying to jump aboard well established trends can be problematic because there can be periods where price stalls, or even threatens to reverse, before extending the trend. In those periods, volatility can increase.

Below I've shown the current chart of EUR/USD as an example.

Here we can clearly see the start of the downtrend from last summer, where the volatility readings were pretty low - both in terms of the 2ATR measurement and the volatility factor. As the trend has progressed, we can see how both these measurements have increased.

What we now have is a 2ATR measurement of over 285 pips. Back in August 2014, it was below 80. That was the lowest reading since its inception back in 1999! Therefore, if I tried to initiate a new position with the current volatility levels, or even if I had a mechanism to pyramid an existing position, price has got to move more than 3.5 times further than it did several months ago for me to achieve a 1R profit.

Is that a good risk:reward opportunity?

This is why my own preference is to get on potential new trends when the volatility measurements are at their lowest - it maximises the potential rewards (in terms of R) you may be able to achieve. Similarly, it is for these reasons why I avoid pyramiding existing trades.

This is not how lots of traders view risk and reward. Typically they may look at price targets and work back from there. But trend followers do not use such targets. They are content to let trends run. They do not place any restriction on the potential profits you can make on a trade. By looking for low volatility set ups, I do not need much of a price movement in my favour to achieve a decent profit in terms of R, in a relatively short period of time. And it is these set ups where the big winners of +20R or more, and therefore the big jumps in your equity, can come from. 

There are some very successful traders out there who use rises in volatility like this as a potential warning sign that current price moves may be about to end. No less a man than George Soros believes that short-term volatility is at its greatest at turning points.

In this particular example, the increase in the volatility measurements would mean that, even if price now moved down to new lows, or if I was looking for a trend reversal to go long, I would not take the trade. Any entry signal would have to be accompanied by a drop in those two volatility measurements.

If I was trading a small basket of stocks, forex or commodities, then my approach may well be different. I would take all the signals presented to me. However, as I potentially could trade any of 10,000+ stocks or instruments, I can afford to be selective and pick those where the potential risk:reward is skewed in my favour.

Therefore, if you do follow price trends, keeping an eye on volatility may help you fish out those setups which may potentially yield a better result in terms of R.

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