ͻ What the Volatility Stop (VS) does.

PROTECTING YOUR TRADES WITH ͻ How to use the VS Study.

ͻ Some basics of how to trade with VS.
VOLATILITY STOP
BY JOE ROSS VOLATILITY

It has been said that 80% of traders are on the Apart from natural support and natural resistance points, moving averages,
right side of a trade when they enter. Why is it and momentum indicators, the market has only one other factor to aid in
that 90% of those traders end up in a losing stop placement. That factor is price volatility. In order to understand how to
trade? Could it be that they simply don’t know use volatility, you first need to understand the concept of volatility.
where to place their stop??
The distance between a price bar’s High and Low is its trading range for the
Volatility gives us prices from which we can technically place and trail period of time represented by that price bar. The arithmetical difference
protective stops. Volatility, used in this way, can show us where prices are between a price bar’s High and Low is volatility. You can use the difference
reversing trend. between the High and Low for any time frame, from one year, to one month,
all the way down to one minute.
The idea of exiting a winning trade in a timely manner is basic to success.
After all, if you can’t take the money off the table while it is there, you Once you have the volatility for one interval of time, you can do the same
cannot succeed at trading. Exiting a trade on time and with a profit is a calculation for any number of sequential periods of the same time interval. If
fundamental concept we teach our students at trading educators. you want to look at the total volatility over a five bar period, you can take the
difference between the lowest Low of the period and the highest High of the
The Volatility Stop gives us a technically based method of stop placement.
period.
Volatility Stop is not divorced from correlation with other indicators that
measure momentum, so it is not to be used for confirmation in association However, it is typical to look at a sequential series of like time intervals by
with any form of momentum oscillator. computing the average volatility over that sequential series. To calculate for
a five bar series you might subtract the Low from the High of each bar, and
In this article we will want to discover:
after five bars total the volatility for all five individual bars, then divide by five
ͻ What Volatility is. to get the five-bar average volatility. Unfortunately, it’s not always that easy.

MAY 2012 ATMASPHERE | 19

 (Figure A) There is a complication. If prices were to for our purposes here in computing the Volatility Stop (VS) for futures trading.
open with a gap up, and the Low for the current price For our purposes in using the VS Study, we will compute the distance from
bar ends up being higher than the previous bar’s Close, each day’s Low to each day’s High, and average them for the past five price
how do we account for the distance that prices actually bars as long as the bars remain normal relative to one another. If there are
moved? Would the true measure of volatility include any abnormally large bars, or any abnormally small bars, or a large gap, we
the distance from the previous bar’s Close to the will average volatility for the last ten price bars.
current bar’s High?
By using more bars for unusual price action, we try to compensate for the
Is this the true measure of volatility? Prices did move fact that the VS Study formulation does not enable us to change parameters
from the Close of the previous bar to the High of the in the way it computes volatility. We would prefer to include gaps, but have
following bar, or is there another way to look at it? no way of indicating them to the study.

(Figure B) What if we measured volatility this When prices expand we see an increased volatility coming into the market.
way? Is it any more right or wrong? When prices contract, so does volatility. The supposition behind the VS Study
is that if a market is very volatile, a stop based upon that same volatility will
Here, we are measuring from Close to Close
give a good indication of where to place a protective stop. Keep in mind that
instead of from Close to High (or Close to Low).
a protective stop may be protecting a loss of profits as well as an outright
Just what is the correct way to measure
loss of margin.
volatility?
COMPUTING VOLATILITY

(Figure C) Here’s a third way:

To compute volatility for any number of price
As you can see, much of how to determine true bars N, we take the sum of the differences
volatility is in the eye of the beholder, and also between the High and the Low for each bar for
depends on the use to which volatility calculations N days and divide by N. We then have the
will be put. For example, in trading options the average volatility for the last N days. We’ll use
method used needs to be much more exacting than

20 | ATMASPHERE MAY 2012

T-Bonds as an example. If you can figure average volatility for the bonds, you We then subtract the whole number away. This will be the mantissa (whole
can do it for anything. When we compute anything to do with the bonds we number) to use for your order. Next, multiply the fraction by 32. This gives
first convert them to decimal values. the remaining thirty-seconds, if any, for the remainder of your order.

To accomplish the conversion, multiply the whole number by 32 and 3287 / 32 = 102.71875 – 102 = .71875
.71875 x 32 = 23
then add the 32nds: Result 102-23

Day High Low Conversion Difference The VS Study provides a way to set stops using a technical indicator, while at

1 103-20 103-08 3316–3304 12 the same time providing a method for following a trend. The VS Study

2 103-16 103-02 3312–3298 14 provides the following parameters:

3 103-14 102-19 3310–3283 27 ƒ Number of bars in the average range.

4 102-27 101-29 3291–3261 30 ƒ A constant value multiplier, typically between 2.8 and 3.1
5 101-29 100-28 3261–3228 33
USING THE VOLATILITY STOP STUDY

Total 116 / 5 = 23.2 Average Volatility The Volatility Stop Study (VSS) simply computes average volatility by
averaging volatility for any number (N) of days you choose, multiplies it by
We then subtract the average volatility figure from our entry price if we are
the factor you choose, and then adds the resulting figure to the lowest Close
long, or add it to our entry price if we are short. If we were to go long bonds
in the last N days, and subtracts it from the highest Close in the last N days.
at 103-14, we would subtract 23/32nds from our entry price and place the
protective stop at 102-23. If we were to go short bonds at 103-14, we would The process of adding and subtracting will yield two prices, one for upper
add 23/32nds to our entry price and place the protective stop at 104-05. volatility, and one for lower volatility. Typically, one of the figures will be for
a price that is inside (within) the range of prices you see on your chart for the
In order to be consistent and also to show how we convert back from
last N days.
decimal to 32nds, note the following steps:
The remaining figure will be either above or below the range of prices you
103-14 = 3310 – 23 = 3287
see on the chart. The VSS will plot only the line that is furthest away from the
To convert back you divide 3287 by 32. This gives a whole number and range of prices. We use the plot line for our stop. We can look at that next.
usually a fraction expressed as a decimal, NNN.xxx.
MAY 2012 ATMASPHERE | 21
 parameters. The next figure shows what happens when we change the

With the VSS set at 5,1 (5 multiplier from 2 to 1.2

bars, with a multiplier of 1)

We see that we can trail
stops below the VSS line in an
uptrend, and trail stops
above the VSS line in a
downtrend.

In case you are wondering, setting the multiplier at ‘1’ nullifies any effects
from the multiplier. Some software allows you to offset the VSS by one bar,
If your software allows an offset moving average, it will look like the chart in
so that at the Close of today you can see where to set the stop for tomorrow.
figure 3. The volatility line will protrude one bar forward. Notice that with the
If you have that capability in you software, use it.
offset, you can set your stop for tomorrow ahead of time.

Note: When the VSS line(s) is running through the price range with prices
With a 7 bar moving
moving sideways, we do not enter any new trades.
average and a multiplier
of 2, a trader could have
trailed the uptrend
(Stop-Close-Only) to the
end of the trend. A fine
feature of the VSS is the
ability to curve fit it to
the angle of ascent of descent of a trend. An example of curve fitting would
be that when you see prices pull away from the VSS line, you change the

22 | ATMASPHERE MAY 2012

 SUMMATION

The Volatility Stop is an excellent tool for staying with the short to medium
term trend. The ability to curve fit it to the price action makes it very useful.
However, as you review this article you must realize that VSS is not truly
adequate for keeping you in a trend for the long-term unless you switch
along the way to the use of a longer term chart.

Joe Ross, a long-time trader, educator and author,

teaches spread trading and day-trading of futures,
Here’s another chart and another market. The Volatility Stop is set to 5, 1.4. Forex, and stocks. Joe still actively trades, tutors and
How can we trade this chart in light of the concepts already presented? writes. You can reach him at the Web site
www.tradingeducators.com.
By the time we reach the point of the lower arrow, we have price
containment by the VSS line. Containment means that the VSS line “contains”
(in this case is below), all of the price action. We trail a stop 1 tick below the
VSS line as prices move up. We can trail Stop-Close-Only, or at the VSS value
of the precious price bar.

Since our VSS setting worked so well going up, we can try it going down. Is it
wrong to curve fit the VSS in this way? Not at all! We are basing what we do
on what prices themselves are doing!

MAY 2012 ATMASPHERE | 23