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Lessons from the Pros - Futures

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Managing Your Trade with ATR

Tue, Nov 17 2009, 13:25 GMT
by Don Dawson

Online Trading Academy

Since my last article, the market volatility has begun to pick up and we are experiencing much larger average daily ranges (average price range from High to Low) in most of the Futures markets. For example, the E-mini S&P had a 14 point average daily range several weeks ago and now has an average range of 24 points. On average, each day the E-mini S&P trades in a range that offers $1,200 from High to Low per contract. This creates great opportunities and also means we need a method to lock in our profits as the market moves in our favor. Trailing stops are used to figure this profit protection.

Two popular types of trailing stops are:

• Manual Trailing Stop

• Automatic Trailing Stop

A manual trailing stop is moved by the trader manually as the market makes new swing highs and lows. This is a chart-based trailing stop and takes into consideration the market structure and trend of the market.

In the chart below, we will assume there was a short position taken near 1064.00 (A). Our original protective stop was above the swing high at 1066.00 (B). After entering our position the market sells off in our favor to point (C). Then we get a retracement back to point (D). During this time, our original protective stop stays in place. Once the market sells off again and breaks the swing low at point (C), we have then created a new swing high at point (D). At this point, we can safely move our protective stop to just above the last swing high at point (D). Our stop is now placed at 1063.00. This is locking in a 1 point profit for us. When the market dropped below point (C), we created another swing low at (E). The market rallies back to point (F) and then sells off. When the market sells off below point (E), we have then created a new swing high at point (F). Immediately, we move our protective stop from 1063.00 to just over point (F) at 1060.50. Now we are locking in a profit of 3.50 points. This process of manually trailing your stop continues as the trend moves in your favor. With each new swing low we locate the last swing high (red arrows) and place our protective stop just above that. Once the market breaks a previous swing high, we will be stopped out of our position with a profit. We will not catch the exact high and low of these moves using a trailing stop. However, we will let our profits run and catch the large percentage of these moves.

The next trailing stop is the automatic trailing stop. My preference is the manual trailing stop simply because it takes into consideration the price action. Since there are so many traders that like to use automatic trailing stops, I thought I would address a way of using it that may help you stay in the trade longer and let the market speak to you for your exit price.

On the TradeStation platform (Figure 2 below), you can enter an automatic trailing stop simply by identifying how many points you want the trailing stop to trail the price action. To send these orders, you just click on "Buy Trl Stp" or "Sell Trl Stp." This sends an automatic trailing stop into the market after you have a position either long or short.

Many traders just use a random number for this stop. The drawback to using a random number is that you are not taking the market volatility into consideration. You may choose a number that works in some market conditions but be too big or small in other market conditions.

For an automatic trailing stop to be in sync with market volatility, you can use a study called average true range (ATR) that is found on all trading platforms. For intra-day charts, the default 14 period works nicely. You can use this automatic trailing stop on any chart time frame you choose (2,5,15, etc, minutes).

Let's look at the chart below and use our ATR indicator located at the bottom of the chart to calculate our ATR automatic trailing stop.
Let's assume we went long this market at (A) 1047.25. Once we get filled, we need an initial protective stop (B) 1044.50. Once the (C) bar closes, we will look below at the ATR indicator and identify what the ATR is (D). At the close of this bar, the ATR was 2.75. Since we are long the market, we need to calculate our protective trailing sell stop. Once we calculate this number, we can cancel our original protective stop and replace it with the new ATR automatic trailing stop. To do this, we take the ATR and multiply it by 2 and come up with a number we will use to trail our stop with. 2.75 x 2= 5.50. The trailing stop 5.50 is subtracted from the (C) bar high of 1048.50.
The new trailing stop becomes 1043.00 (E). With each new bar that makes a new high for the move, we look at the ATR indicator below and multiply the number by 2. Then we subtract that total from the high of the bar. Remember, the bar must have made a new high for the move. If the bar was equal to or lower than the previous high, we leave the previous ATR stop in place.

The market continues making new highs for the move until bar (F), red arrow. Since the previous bar was the last bar to make a new high for the move, we will keep the trailing stop at the level generated on that bar until we make a new high for the move. At (G), we made that new high for the move. We look down at the ATR indicator and take the ATR and multiply it by 2 and subtract that number from the high of (G) for our new trailing stop. The high of (G) was 1054.25. The ATR below that bar was 3.00. 3.00 x 2=6.00. Now our new trailing stop is 1054.25 – 6.00 = 1048.25. The market retraced to 1049.25 (H). Our stop still has not been hit and we continue to be long this market.

During the next several hours the market would retrace but never hit our ATR trailing stop. Finally at (I), the market peaked and we calculate our ATR trailing stop again. The high of (I) was 1060.50. The ATR was 1.25. 1.25 x 2=2.50. We take the high of 1060.50 and subtract 2.50 and get a trailing stop of 1058.00.

During the (J) bar, our trailing stop was finally hit. We had entered the market at 1047.25 and exited at 1058.00 for a nice profit of $537.50 per contract.

This illustration was for a trailing stop under a long position. For a short position, we do the opposite and add the ATR x 2 to the lowest bar of the move.

Here are two strategies for managing your trade once you have entered the market using a trailing stop. Both will help you stay with the trade longer and make more money in return. There is a saying in the market, "You cannot go broke taking profits." By selecting price targets to exit all of our positions, we are literally cutting our profits short. Nobody knows how far a market will go each day.

Published on  Tue, Nov 17 2009, 13:25 GMT