In order to offer some additional guidance to our ATR Trailing Stop study, here is an excerpt from the weekly TechStats report by Leon Wilson. (Our study draws the ATR as a line rather than dots, but the concept is the same.) Enjoy!
“Where to sell?” That is the question. It is not in our nature to sell when trading as many of us perceive this as an admission of failure, especially where losses are involved. The true acknowledgement of failure is when we know that we should have sold, yet for what ever reason we hang on to our position.
Discipline and experience can overcome this problem when combined with a suitable trailing stop which will define our exit point with clarity. A common trailing stop strategy is to apply an ATR (Average True Range) trailing stop below price action.
For those of us not familiar with the ATR indicator, it basically measures the range of price volatility over a specified period in relation to the closing price. The ATR value is then usually multiplied by a factor of 2 for short term trading and by 3 for longer term trading time frames.
The idea behind the multiplication factor is to offset the trailing stop away from price action in order to allow for natural price movement. Negative movement beyond these ranges is considered as a potential change in market sentiment and time to close our position. The MetaStock formula for the classic ATR trailing stop is as follows:-
CLOSE - (2xATR(5))
The most common approach with ATR trailing stop application is to apply the indicator by displaying it as a series of dots. The trader only references the highest dot that appears on the chart , ignoring any surrounding dots with a lesser value. The ATR trailing stop is only adjusted when a new dot appears with a higher value. I have personally found that joining the dots was a bit much and appeared messy on the chart, when the chart included several months of data.
It also allows for human error to occur by us manually referencing the incorrect trailing stop value. Our 1st chart is the classic ATR trailing stop display set at 2xATR(5).
With our 2nd and 3rd charts I have used my own personal trailing ATR stop so that we can more clearly examine the relationship between the trailing stops and price action. Our 2nd chart has the trailing stop applied at 2xATR(5).
It hugs price action nicely for the entire duration of the uptrend. While it is not clearly visible here as I have enhanced the lines for the purpose of the article, we never experienced a close below our trailing stop. On several occasions we did experience a close equal to our ATR trailing stop, however this does not translate to an exit signal.
We will consider that an exit signal has been generated when we have received a close below our ATR trailing stop value.
We can quickly ascertain from a visual assessment of the chart that a 2xATR trailing stop works relatively well with this stock at this point in time. I have found from personal experience that our trailing stop is synchronised with trending price action when we experience retracements or periods of consolidation that will tag the trailing stop without us experiencing a close below it. This is readily apparent with our 2xATR stop where pauses in price action have seen the lows rest on the trailing stop line while we received no exit signals.
By synchronising your trailing stop to price action it ensures that when we do receive an exit signal it carries sufficient significance for us to take notice and act. To employ a trailing stop that continually ejects us from our trades prematurely, alternatively decimating our profit and trading capital by closing us out to late eliminates our confidence in its ability to be of any benefit to our trading. The end result of an erratic or incorrectly set indicator is that we end up flying by the seat of our pants and Murphy's law dictates that this will be to our detriment.
We received a clear exit signal in late May with a close below our ATR trailing stop. We have one small dilemma of price action still being above our upward trend line. Do we wait and see if price action bounces of the trend line before closing out the position. My own personal decision would be to close out the position if the underlying upward trend line has had no influence in my monitoring process with the trade to date. The trailing stop has not generated one false signal for the entire uptrend therefore I have no justifiable reason to question the validity of the signal.
Exits are as much about judgement as they are timing. While we may have used one specific entry 11/04/2003 technique, as traders we like to make life difficult for ourselves by applying multiple exit strategies. I tend to minimise by exit strategies to ATR and count back exits. Multiple exit strategies applied to one trade creates multiple grey areas and multiple lines of confusion with undefinable price action.
I suggest that you select your preferred exit strategy and stick with it. Multiple exit strategies can be applied, but experience and discipline is required to make this approach consistently effective. The reluctance to sell will see us continually going for the stop with the lower value. Such actions are a direct contradiction to the purpose of a trailing stop. In the end the decision rests with the individual, but what I suggest you do before you open the trade is decide what your actions will be as a 2xATR stop will create this situation occasionally.
Our final chart has the ATR trailing stop displayed at 3 times the ATR range. In my opinion our trailing stop is too far removed from price action. There are sections of the up trend where too much profit is put at risk and ideally we would like to see our trailing stop relatively close to consolidating price action. There is no guarantee that prices will break up from any period of consolidation, so ideally we need to keep any adverse effect of negative price movement to a minimum.
This is normally achieved by having our trailing stop placed fairly close to consolidating price activity. In my opinion a 3xATR trailing stop falls short in this department. When we finally received our exit signal it occurred in late May almost one month later than our 2xATR trailing stop. If we closed our position at the opening of trading the next day following the exit signal being generated, then we would have liquidated our position at $0.79 using the 2xATR trailing stop. The same scenario would have seen us close out our position at $0.66 with our 3xATR trailing stop.
This has seen a sacrifice -16.45% with regard to available profit that was there for our taking. This is not hypothetical profit as we have used trailing stops and market values to determine exit prices for our down side. We must also take into account that we have had funds tied up for what was almost a month that generated no additional income. We could have collected our extra profits one month earlier and moved on to other trading opportunities. The formula for the 3xATR trailing stop is as follows:-
CLOSE - (3xATR(5))