V.11:10 (432-436): Redefining Volatility And Position Risk by C.A. Kase, C.T.A.

Redefining Volatility And Position Risk by C.A. Kase, C.T.A.

A method on looking at the volatility of intraday price bars using a stop system called the "dev-stop."

Volatility is the key to understanding market behavior. Volatility is the change in price and thus, by definition, is directly related to price. I normally use true closing range (TCR) as a measure of volatility rather than the annualized price probability that options traders employ. The true closing range is the largest absolute value of three possibilities: (1) high minus low, (2) high minus previous close or (3) low minus previous close. This is expressed in the same units as the underlying contract or issue we are trading. Specifically, the true closing range tells us the maximum theoretical amount of money we could have made or lost between the close of one bar to the next. Thus, it is easier for a stock or commodity trader to relate to than a percentage measurement.

USING VOLATILITY

As traders, our primary interest is volatility itself. If price does not change, you cannot make any money. Of course, without price change you can't lose any money, either. Thus, both reward and risk are directly related to volatility. By defining volatility in terms of range, we can develop rules (algorithms) for stops that may be universal, working in all markets in all timeframes. We can use the volatility of range as a substitute for fixed estimates of stop sizes and thus develop a system that will expand and contract — breathe, if you will — with the market's own activity. For example, one published system that is an improvement over using a fixed value as a stop employs the average true range times a fixed value, say 3. So, as volatility increases and decreases, the stop also expands and contracts.

One problem with this approach: Market conditions may dictate that narrower or wider stops be used depending on the status of the trade. For example, during a surging impulse move, when danger of a reversal is low, a trader may want to use a wide stop. At other times, when danger of a reversal is increased — such as when momentum divergence is present — the trader may wish to use a narrow stop. Problems remain, however, even if we use different factors or multipliers for different conditions.