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www.tradersonline-mag.com 07.2013
How to Find good Long trades after a sell-off
Look Out for extreme Volatility
Prices are known to move in trends. If you prefer to trade trend-following setups, it is
necessary for such a trend to have already emerged. But what would it be like if you
were to see the beginning of a new uptrend early on, allowing you to participate in the
subsequent movement or benefi t from it? Here is a trading strategy you can use to
spot such excellent entry opportunities on the basis of volatility.
» Point of DepartureVolatility – reflected by the width of the Bollinger Bands – is
a simple tool to determine the beginning of a new uptrend
or a good entry opportunity. The width of the Bollinger
Bands is determined by volatility. Just like the Simple
Moving Average (SMA), this is calculated by the middle
Bollinger Band over a period of 20 and drawn upwards
Marco Baeger
Mr Marco Baeger, who completed a comprehensive training programme to qualify as a fully-trained bank clerk, has been trading his own account since 2009, specialising in trading EUR/USD and the DAX via CFDs. His trading approach is based on the combination of price and volume data. In addition to the above, he is also a freelance writer.
http://mbteurotrades.blogspot.com
Marco Baeger
Mr Marco Baeger, who completed a comprehensive training programme to qualify as a fully-trained bank clerk, has been trading his own account since 2009, specialising in trading EUR/USD and the DAX via CFDs. His trading approach is based on the combination of price and volume data. In addition to the above, he is also a freelance writer.
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and downwards in a “normal” distance of two standard
deviations from the middle band. This is the context within
which approximately 90 per cent of all price movements
materialise. If the price is outside the bands, a rather
unusual level has been reached which should be corrected
in due course.
To find an even more extreme level of volatility in an
existing downtrend, Bollinger Bands will additionally be
used with a 50-period SMA and a standard deviation of
2.1. In a less volatile price development, the 20-period
Bollinger Band moves within the 50-period Bollinger
Band. In short periods of extreme volatility, however, the
lower 20-period Bollinger widens to such an extent that it
is listed outside the lower 50-period Bollinger Band.
Assuming mean reversion, we can expect these rare
sets of circumstances to be corrected, the price to move
back into the bands and even the shorter-period Bollinger
Band to run back into the longer-period Bollinger Band.
The unusual expansion of volatility over 20 periods
which has been described above is the point of departure
for the strategy presented here. A bottom or a trend
reversal is assumed to materialise.
Buy when the Strong Hands BuyIn intact trends, price movements are confirmed by
volume. If that correlation changes, this indicates the
possible end of a trend or an impending change in
trend. The Accumulation Distribution Line (ADL) makes
it possible for such shifts to be detected early. It is a
volume-weighted price-change indicator reflecting the
liquidity flow of the underlying’s movement. So you can
see whether it is accumulation (buying pressure) rather
than distribution (selling pressure) that predominates. If
the ADL is shown as a histogram in the chart, the volume
trend – just like the price trend – will be judged by the
sequence of highs and lows. The break of the most recent
lower high in the ADL indicates the end of the distribution,
or the onset of an accumulation. This may be a further
indication of the likelihood of a new uptrend beginning.
Kaufman’s Adaptive Moving Average – Filter and Stop Loss at the Same TimeOnce the requirements for a potential market entry are
defined, a filter is still needed to reduce the risk of failed
trades. Since the approach is based on a movement
against the existing trend, the price should first confirm
that it is, in fact, moving in the direction predicted.
Perry J Kaufman’s Adaptive Moving Average (KAMA
for short) automatically adjusts its speed to the volatility
of the market. In contrast to the Bollinger Bands, KAMA
has its volatility calculated by the Efficiency Ratio (see
info box), causing market noise to be filtered.
KAMA’s speed automatically adapts to the volatility of the market. In periods of high volatility – when the overall market
moves sideways – KAMA responds very sluggishly (reaction time is extended). If the market goes into a trending movement,
KAMA’s speed will increase (reaction time is reduced). This is achieved by calculating the efficiency (Efficiency Ratio) of the
price movement in a given period. The Efficiency Ratio represents the ratio of the net to the gross price movement based on
the calculation of an Exponential Moving Average. The net price movement is defined as the absolute price change over the
period under consideration, i.e. the difference between the first and last day in the period under consideration. The gross price
movement is the sum of all price changes in the period under consideration. The Efficiency Ratio is designed to show how
efficiently a price movement has developed over a period of several days. If prices have been moving linearly in one direction,
the ratio of net to gross price movement is close to one (= high trend efficiency). If prices have behaved in an extremely volatile
manner, the ratio of net to gross price movement is much smaller and close to zero (= low trend efficiency). The Efficiency
Ratio varies between the maximum values of zero and one. KAMA responds to changes in direction within a distinct trend
faster than to changes in direction in volatile sideways phases. It runs almost horizontally in sideways phases, indicating the
absence of a strong trend movement.
Kaufman’s Adaptive Moving Average (KAMA)
In intact trends, price movements are confirmed by volume.
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www.tradersonline-mag.com 07.2013
This means that KAMA runs
almost horizontally in periods of
sideways prices. However, once a
trend move has emerged, KAMA will
be responding relatively quickly and
follow the new direction.
The basic condition of this setup
is an unusual expansion of volatility
in the longer term time frame.
However, if the price or trend is meant
to change its direction, decreasing
volatility must be evident in the
short term. In the standard setting,
KAMA is calculated over ten periods,
ideally reflecting the short term time
frame. Consequently, breaking the
sideways KAMA from the bottom up
is the trigger for market entry.
At the same time, KAMA – in its
capacity as a trend filter – serves as
an accompanying stop-loss level.
After all, it is important to benefit
from a marked movement and not
be unnecessarily at the mercy of the
seemingly arbitrary price action in
sideways phases.
SetupBriefly summarising the setup, the
basic requirement is a 20-period
Bollinger Band which is below the
lower 50-period Bollinger Band.
The price is quoted here in the low
outside the lower 20-period and/
or lower 50-period Bollinger Band.
At this point, the search in the ADL
is on for a break of the downward
trend (formation of higher high).
Finally, the crossing of the sideways
10-period KAMA will be awaited.
Only thereafter an entry will be
made. The initial stop loss is the last
swing low provided that KAMA had
In early November, there was a volatility expansion, albeit without generating an entry signal. In January 2013, there finally was a valid entry signal. The bars below the chart show the ADL. SL = stop loss.
Source: www.tradesignalonline.com
F1) Fresenius Medical Care
Figure 2 additionally shows the 200-period EMA (pink) and 200-period SMA (purple). The end of the consolidation was tantamount to the test of these two Moving Averages. What is remarkable about this trade is the kind of price potential that is released by a suddenly beginning accumulation. SL = stop loss.
Source: www.tradesignalonline.com
F2) essilor international
KAMA runs almost horizontally in periods of sideways prices.
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not yet been crossed – or the low of the last candle below
KAMA if the latter had already been crossed. The use
of KAMA as a trailing-stoploss will be explained in the
following trade examples.
In Figures 1 to 3, the 20-period
Bollinger Bands are shown in black
and the 50-period Bollinger Bands
in blue. KAMA can be seen as a red
solid line. Below the price window,
the ADL is shown as a histogram.
For the purpose of evaluating the
development of the indicator, the
20-period Bollinger Bands as well as
KAMA will also be applied to the ADL.
Strategy Example 1: Fresenius Medical CareIn November 2012, the Fresenius
Medical Care stock experienced a
volatility expansion as described
above, which occurred within
a larger sell-off. Also, the price
was quoted far outside the lower
20-period Bollinger Band. However,
the second requirement did not
materialise; the ADL failed to stop its
downward trend.
The increase began with a V-bottom. The entry price was relatively far from the lowest price. If you then were to place the stop loss at this low, the risk/reward ratio would be nowhere near as lucrative as in this setup with a stop loss below KAMA. SL = stop loss.
Source: www.tradesignalonline.com
F3) Merck Kgaa
T1) trading results
Trade 1: Fresenius Medical Care Trade 2: Essilor Trade 3: Merck
Order: Stop buy Order: Stop buy Order: Stop buy
Entry: 17th Jan 2013 Entry: 22nd Feb 2013 Entry: 19th Feb 2013
Entry price: €50.33 Entry price: €74.59 Entry price: €104.10
Initial stop loss: €49.26 Initial stop loss: €71.69 Initial stop loss: €100.00
Exit: 6th Feb 2013 Exit: 21st Mar 2013 Exit: TBD
Exit price: €51.44 Exit price: €85.24 Exit price: TBD
Profit: €1.11 Profit: €10.65 Profit:€9.30 (with SL 8 at €113.40)
Profit/risk: 1.04 Profit/risk: 3.67 Profit/risk:2.27(with SL 8 at €113.40)
In January 2013, there was another volatility
expansion. The rally helped ADL to form a higher high.
At the same time, the stock moved above the sideways
KAMA. The stop-buy order was placed above the high of
KAMA – in its capacity as a trend filter – serves as an accompanying stop-loss level.
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Strategy name: Volatility Expansion
Strategy type: Indicator-based
Time horizon: Daily chart
Tradable Instruments: Shares
Indicators: Bollinger Bands (20-period and 50-period), Accumulation Distribution Line (ADL), Kaufman’s Adaptive Moving Average (KAMA)
Setup:
Long only; speculation on rising prices due to an unusual expansion of volatility over 20 periods; accumulation of the stock – confirmation by trend change in the ADL
Entry: Stop-buy order above KAMA or above the candle, which has moved above KAMA
Initial stop loss: Last swing low or low below KAMA
Trailing-stop: Low below KAMA
Exit: Break of the low of the last candle below KAMA
Risk and money management:
1% risk per Trade
Average number of signals:
Depending on Market
Strategy Snapshot
the candle breaking through. The initial stop loss was set
below the same candle since the low was already below
KAMA. The price initially rose dynamically, but then
went into a sideways movement at the middle 50-period
Bollinger Band, causing KAMA to move sideways as well.
Accordingly, the stop loss below KAMA was adjusted and
triggered.
Strategy Example 2: Essilor InternationalAt Essilor, a volatility expansion at the end of a sideways
consolidation was evident in mid-February. At the
beginning of volatility expansion, the lows were outside
the lower 20-period Bollinger Band with the absolute low
later being “only” outside the lower 50-period Bollinger
Band. At this point in time, there was a huge increase
in the ADL immediately surpassing all previous highs.
Still, it took several days for the stock to eventually break
upwards through KAMA and rise to a new all-time high.
In Figure 2, each of the trailing-stops is provided with an
arrow. After completion of the first candle marked with
an arrow, the stop loss was raised to this level. The stop
loss is always placed below the low of a candle, which
is also below the current KAMA. The vertical auxiliary
lines of the arrows help to understand where KAMA was
quoted at this point in time. The steep rise ended in late
March, so the trade was terminated with the trigger of
trailing stop number seven.
Strategy Example 3: MerckIn early February 2013, Merck marked a low that was
below both lower Bollinger Bands at the same time. The
stock subsequently reversed upwards, forming a “V”. It
wasn’t until five days after the low that a higher high was
established in the ADL. At this point in time, the stock had
already beaten its KAMA. This made it possible for the
stop-buy order to be placed directly above the high of the
candle of the ADL high. The initial stop loss was placed
below the low of the last candle below KAMA. As a result,
the stock rose to a new all-time high. As of 31st March
2013 (time of writing the article), the trade is still open.
Table 1 provides details of all three trades. For the
Merck trade it indicates the profit made up to trailing-stop
number 8 valid until then.
ConclusionThe strategy specifically seeks to identify any unusual
volatility expansion. Once the strong hands start buying at
this time, trades with a high risk/reward ratio may result.
Using the stop loss below KAMA immediately
closes the trade if a changing movement pattern occurs.
However, it is possible for the trend (succession of higher
lows) to still be intact at this time. That is why other
stop-loss methods are also conceivable – for example,
below the most recent higher low. Regardless of this, it is
recommended that partial profits be realised from a level
of four to five times the risk taken (4R or 5R). Essilor trade
profits were peaking at more than 5 R, falling to “only”
3.67 R at the end of the trade.
Of course, each of the components of the strategy
presented can also be used just by itself. For example, the
author also uses KAMA when day trading the DAX and
EUR/USD in order to assess the trend in a 5- or 15-minute
chart.«
The strategy specifically seeks to identify any unusual volatility expansion. Once the strong hands start buying at this time, trades with a high risk/reward ratio may result.