Trader's Daily Notebook: Volatility Filter Is a Risk Management Tool

 | Jun 12, 2017 | 7:00 AM EDT
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Stock quotes in this article:

amzn

If you missed Friday's primer on average true range (ATR), give the piece a quick read before continuing on. Go ahead, I'll wait. 

OK, now that we all have a reasonable understanding of what ATR is, let's jump into a few charts and discuss how we can implement the ATR indicator into our own swing trading systems. 

Amazon (AMZN) -- Daily, Chart 1
 
Amazon (AMZN) -- Daily, Chart 2
 

Given the number of readers who have expressed frustration with trying to jump on the runaway train that is FANG, I thought we'd begin with one of the market's momentum darlings, Amazon (AMZN)

As you review the two charts above, please note there is a 10-day and 21-day exponential moving average (EMA), as well as a 50-day and 200-day simple moving average (SMA). The two dotted lines on either side of the red 50-day SMA represent one 10-day ATR above and beneath the 50-day SMA. And just so there is no confusion, you can use whatever ATR setting you wish. I happen to be comfortable (via my own testing) with a 10-day ATR, so that's generally what I stick with. 

In the first chart, you can see where price broke beneath both the 50-day SMA and the -1 ATR marker in a single bearish gap (shaded in red). From a trading perspective, the fact that this occurred on strong volume would lead us to believe the move is not random noise, and is likely to weaken further. From the day AMZN broke the 50-day SMA in early January 2016, the stock trended lower until late March when it popped back above the 50-day SMA on slightly higher than one-month average volume (shaded in green). 

Switching over to the second Amazon chart above, we see a sharp break beneath the 50-day SMA in late October 2016 (shaded in red). The break is on extremely heavy volume, and leaves price well beneath the -1 ATR marker. While price never collapses, and ultimately remains above the higher timeframe 200-day SMA, a trader never could have known for certain whether the initial break of the 50-day SMA would lead to a 30%, 40% or even 50% drop in price. However, by simply re-entering the position once the 50-day SMA is recaptured on strong volume in early January (shaded in yellow), a trader never had to worry about the potential for a more meaningful collapse. Waiting to enter until price broke 1 ATR above the 50-day SMA simply adds another level of confidence that some traders might find mentally reassuring. 

We all know trading is about making decisions on less than ideal, and often incredibly incomplete, information. By implementing a volatility filter, or an ATR, to our decision process, we're able to further reduce the likelihood that we'll be forced out of a position by random, shorter timeframe noise. So while the strongest of trends, such as those we've seen in many of the FANG stocks this year, may never come close to breaking their 50-day moving average, let alone probing a measure of volatility beneath said moving average, not every stock will move from the lower left to upper right with uninterrupted ease. And this is when a volatility filter earns its place in our trading system.

A quick side note on one's choice of moving average: If tracking an ATR based on a 50-day SMA results in too wide a stop for your system (this is often the case when chasing momentum far from the breakout point), the same ATR concept could be applied to an eight-, 10- or 21-day moving average as well. In fact, as trends develop and become steeper, it's often a good idea to adjust your stop to a shorter timeframe to avoid an unreasonable (from a risk/reward standpoint) drawdown. Ultimately, the goal is to determine which method, timeframe and risk parameters suit your own style. 

Any trading or volume profile related questions can be posted in the comments section below, emailed to me at parkcityyeti@gmail.com or posted to my Twitter feed @ByrneRWS 

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