VOLATILITY INDICATOR
Editor,
The September 1998 article "Trading The Trend" by Andrew Abraham,
in which he presented a volatility indicator, doesn't provide the information
necessary for the educated layman who is interested in technical analysis.
In my opinion, it should have provided more detail on some areas.
I understand the calculation of a 21-period weighted average of the
true range, but why is the final value multiplied by 3? Is the volatility
indicator in a rising market calculated by subtracting the 21-period weighted
average of the true range from the highest close in the same 21-period?
Then when the market closes below the volatility indicator, is the
volatility indicator calculated by adding the next day’s value of the 21-period
weighted average of the true range to the lowest close in the 21 periods?
I hope you can clarify this for me.
Tony Ramselaar, via E-mail
Weert, The Netherlands
The volatility indicator discussed by Abraham in the article was originally
introduced by J. Welles Wilder in New Concepts In Technical Trading, published
by Trend Research in 1978, available from the Delta Society (336 698-0500).
Wilder explains that the constant used in the volatility system can range
from 2.80 to 3.10 and was found by testing. The volatility indicator is
a trailing stop-and-reverse approach. The volatility indicator is the average
true range multiplied by the constant and subtracted from the highest close
for long positions. Thus, if you are long, you should go short if the market
closes below the volatility indicator. While you are short, the volatility
indicator is added to the lowest close, and you go long if the market closes
above the volatility indicator.
I hope this helps to fill in the gaps for you. -- Editor
SPREADSHEET CALCULATIONS APPRECIATED
Editor,
I have been a subscriber to your informative publication for a number
of years and enjoy the articles very much. I wish to commend you on the
February 1999 article "Directional Movement" by Stuart Evens. The sidebar
on the calculation method for a spreadsheet is most appreciated.
I would like to perform similar calculations for mutual funds, which
usually report the Nav (net asset value) at closing, with no mention of
high and low. Could you advise me on how to modify the calculations to
accommodate mutual funds?
I would also like to request that you consider an article on point
and figure charting and include appropriate spreadsheet calculation methods.
Thank you for a job well done.
W.E. Wright, via E-mail
Since no high or low is given for mutual funds, you can't work with a price
range, which is what the directional movement indicator is based on. Perhaps
you could try substituting the closing price for the high and low, which
would give you the directional movement of the close only. I haven't tried
this; let us know if it works! --
Editor
VOLUME-PRICE RELATIONSHIPS
Editor,
Thank you for your very helpful response to my last letter, and congratulations
on maintaining the high standard of your excellent magazine.
The use of volume-price relationships has obvious merit for the assessment
of market interest in a share, and I am aware that some proprietary software
aims to track the accumulation and divestment of stock. However, this would
appear to be mostly tied to the provision of data, and as I prefer to use
a spreadsheet-based system of my own, I am seeking sources of formulas
suitable for such a system. Can you suggest any sources?
Trevor T. Bestow, via E-mail
See Staff Writer Stuart Evens' article in this issue, "On-Balance Volume,"
which includes a sidebar on calculating OBV in a Microsoft Excel spreadsheet.
-- Editor
MONEY MANAGEMENT
Editor,
I have subscribed to your magazine for over a year now and enjoy
the ideas and articles. However, as with most investment products, including
software, I rarely find discussions on money management.
One of the first books I read on trading and a most highly regarded
book in the industry, Market Wizards, showed that the key to success in
this business is managing trade size and risk. While I know you have had
articles on this subject, I believe it should be a regular topic. For example,
how much of my portfolio should be in the market at one time? How should
I size each trade? How much should I risk in each trade? How much should
be in one segment of the market (for example, high techs)?
Most new investors and traders look for the Holy Grail system, or
ways to get into the market. However, I believe that trading really begins
once you are in a trade. I am also disappointed with the lack of software
focused in this area. Most packages don’t include portfolio tracking, let
alone providing useful information to help you size your next trade and
understand your past trade performance. Learning from your past trades
is one of the most powerful tools in helping one improve performance.
The market appears to be focused on the sizzle, not the real meat.
Remember the only requirement to enter this business is cash. I hope your
magazine will help readers keep their cash by providing better information
in the area of money management.
Mike Schwartz, via E-mail
We agree that money management is a priority in trading, and we have published
many articles over the years on money management, position size, risk,
and setting stop-losses. Thank you for reminding us that traders cannot
be successful for long without money management strategies in place.
In addition to a series of articles last year by Jeffrey Owen Katz and
Donna L. McCormick on exit strategies and setting stops, as well as some
discussion of trade management and money management in our monthly interviews,
and the insight offered over the years by Technical Editor John Sweeney
on risk and position size, here are a few other recent articles on the
topic of money management. In addition, see also the next letter, "Variability
of returns." -- Editor
Matching Money Management With Trade Risk (Volume 16, May 1998)
by Daryl Guppy
Manage your trades using technical analysis by identifying risk points
as well as setting profit objectives.
Secure Fractional Money Management (Volume 16, July 1998)
by L. Zamansky, Ph.D., and D. Stendahl
Here's how to find a new fractional value of capital to invest in every
trade to maximize returns subject to a constraint on drawdown, using a
variation of the optimal f money management strategy.
Zero Cost Averaging (Volume 16, April 1998)
by Terrence M. Quinn and Kristin A. Quinn
This technique steps in to assist in the management of the investment
after the investor has determined which securities to purchase and when
to open the position.
The Basics Of Managing Money (Volume 15, September 1997)
by Mark Vakkur, M.D.
Why is money management one of the first items that professional traders
stress? Here's an overview of risk and several simple mechanical approaches
to money management.
Trading With A Variable Position Size (Volume 14, May 1996)
by Tom O'Malley
Once a position has been put on, some traders will hold it at a constant
size throughout the life of the trade, while other traders will vary the
size. Which is better?
Charting Equity (Volume 14, May 1996)
by Joe Luisi
Information on money management, what it is and how to use it can be
hard to come by. Few traders understand or use money management techniques.
Here are several techniques that you can use to get a better understanding
of money management.
Using Maximum Adverse Excursion For Stops (Volume 5, April 1987)
by John Sweeney
The lesson here is: Minimize the size of your largest loss. Study past
contracts to determine their maximum adverse excursion under the trading
rules you use. I use a simple trend-following system with rate contracts
and currencies.
VARIABILITY OF RETURNS
Editor,
I found Technical Editor John Sweeney's articles about volatility
of returns in the May 1998 ("Volatility Of Returns") and December 1998
("The Volatility Edge") STOCKS & COMMODITIES
confusing. I am having trouble sorting out the difference between trading
volatility and variability of returns as volatility is described in the
articles.
As I understand the markets, volatility is important to make markets
work, and investors or traders are always trying to limit the variability
of their returns. I agree with Serguey Sayta's comment given in the December
article that other things aren’t always equal. Sayta suggested one approach
to improve the number of positive trades compared with the number of negative
trades. But what about the size of the positive trades compared with the
size of losing trades? What about diversification?
In the May article, Sweeney allowed the returns to range randomly
from -50% to +50%. I assumed that this represented the size of the losses
or gains from each trade. The importance of exit strategies to limit the
size of the ratio of the losses to the size of the winning trades has been
covered in many articles and interviews in STOCKS &
COMMODITIES. The importance of money management can
also be shown by altering the random return volatility spreadsheet. In
so doing, it becomes very apparent that limiting the size of the losses
is one of the most important things that an investor or trader can do to
improve performance.
Along this line, Sweeney pointed out in Figure 4 of the December
article that limiting losses and letting profits run is an old axiom. It
is still one of the most important things required to make a person a good
investor or trader.
The importance of diversification for protecting capital and limiting
risk has also been covered in many articles and interviews in STOCKS
&
COMMODITIES. A well-diversified portfolio will go
a long way toward limiting the variability of returns.
In sum, a person following his trading plan and limiting the size
of his losses should limit the negative side of the returns to much less
than -50%. By using diversification, he should smooth out the variations
in returns. Throw in more positive returns than negative, as suggested
by Sayta, and that person will be trading successfully for many years.
Ethan A. Schrader, via E-mail
VOLATILITY DATA VIA INTERNET
Editor,
I enjoyed your review of the OddsCalc software in the February 1999
STOCKS & COMMODITIES. Your
inclusion of Websites that give volatility data was useful information.
Please allow me to also point out our Website, http://www.optionstrategist.com,
where we post free volatility data weekly. It includes various measures
of historical (statistical) volatility, as well as the current implied
volatility reading and the percentile of implied volatility for all 3,000
or so entities that have listed options.
Experienced option traders are using sophisticated probability calculations
these days. A Monte Carlo simulation is helpful to provide an idea of the
probability of a stock or future ever hitting a breakeven point during
the life of a position — not just the probability at the end of the option’s
life. This is particularly necessary for naked-option writers.
For example, in the review, an example is given where a naked orange
juice strangle is written based on the fact that there is an 83% chance
that the out-of-the-money options will expire worthless. However, a naked-option
writer will normally take defensive action if his naked options go into-the-money
at any time during the life of the position. So the real probability that
one needs to know is, "What are the chances of orange juice ever
hitting the call's strike or the put's strike during the time between
now and expiration?" That chance is going to be much less than 83% -- perhaps
something on the order of 60%. At a 60% probability, one might not actually
take the trade.
So, when using probability calculations, an option trader must be
careful to calculate the probability of what he is actually going to do
while the position is in place. If one plans to blindly stay short the
naked strangle until expiration, no matter what happens, then the probabilities
as shown in OddsCalc will suffice. However, if one plans to take defensive
action to prevent large losses, then I would recommend a Monte Carlo simulation.
Lawrence G. McMillan
President, McMillan Analysis Corp.
http://www.optionstrategist.com
E-mail: mac19@ix.netcom.com
BEGINNER TRADER NEEDS HELP
Editor,
I am interested in learning more about what traders do, how they
make money, and becoming a home trader at some point.
Do you have any suggestions for beginner reading material that would
explain the basics? How about something that would enable me take part
in some active trading?
Jason W. Jones, via E-mail
Here is a list of classic reading material on technical analysis and the
stock market:
Colby, R.W., and T.A. Meyers [1988]
The Encyclopedia Of Technical Market Indicators, Dow Jones-Irwin.
Edwards, Robert D., and John Magee [1997]
Technical Analysis Of Stock Trends, 7th ed., Amacom.
Fosback, Norman G. [1985]
Stock Market Logic, The Institute for Econometric Research.
Graham, Benjamin, and David Dodd (originally); Sidney Cottle et al.
(5th ed.) [1988]
Graham & Dodd’s Security Analysis, 5th edition, McGraw-Hill.
Krausz, Robert [1997]
A W.D. Gann Treasure Discovered, Geometric Traders Institute,
Inc.
Meyers, Thomas [1989]
The Technical Analysis Course, Probus Publishing.
Murphy, John J. [1991]
Intermarket Technical Analysis: Trading Strategies For The Global
Stock, Bond, Commodity And Currency Markets, John Wiley & Sons.
_____ [1997]. The Visual Investor, John Wiley & Sons.
O'Neil, William J. [1988]
How To Make Money In Stocks, McGraw-Hill.
Pring, Martin J. [1985]
Technical Analysis Explained, McGraw-Hill.
____ [1992]. The All-Season Investor, John Wiley & Sons.
Rhea, Robert [1934]
The Story Of The Averages, Rhea, Greiner & Co.
_____ [1962]. The Dow Theory, Rhea, Greiner & Co.
Sperandeo, Victor [1991]
Trader Vic: Methods Of A Wall Street Master, John Wiley &
Sons.
Wyckoff, Richard D. [1931]
The Richard D. Wyckoff Method Of Trading And Investing In Stocks,
Wyckoff Associates, Park Ridge, IL.
Here are some classics on commodity trading and technical analysis:
Kaufman, P.J. [1987]
The New Commodity Trading Systems And Methods, John Wiley &
Sons.
Murphy, John J. [1991]
Intermarket Technical Analysis: Trading Strategies For The Global
Stock, Bond, Commodity And Currency Markets, John Wiley & Sons.
_____ [1986]. Technical Analysis Of The Futures Markets, New
York Institute of Finance.
Schwager, Jack D. [1984]
A Complete Guide To The Futures Markets, John Wiley & Sons.
_____ [1996]. Schwager On Futures: Technical Analysis, John
Wiley & Sons.
_____ [1995]. Schwager On Futures: Fundamental Analysis, John
Wiley & Sons.
For getting started with trading, you may wish to paper trade or practice
with a simulation program first (several have been reviewed in this magazine
in the past year or two) while you work out a trading plan. -- Editor
NEW BEAR FUND FROM RYDEX
Editor,
Since I prepared the February 1999 article on designer funds for
STOCKS & COMMODITIES, a new
and important fund has since become available from Rydex Corp. that I wanted
to mention -- the Arktos fund (RYAIX).
This fund is important because it has the objective of moving inversely
to the Nasdaq 100 and thus provides a convenient opportunity for "shorting"
the Nasdaq 100. Rydex's Otc fund moves in unison with the Nasdaq 100, so
these two funds can make a great pair for trading models. The Arktos fund
is now a very significant fund with more than $70 million invested as I
write this letter in February 1999. By the way, the word "Arktos" has real
meaning -- in Greek, it means bear.
Gary H. Elsner, Ph.D.
Editor, Achieve Profits, Inc.
http://www.AchieveProfits.com
ERRATA: TRADERS' TIPS
Editor,
In reviewing the TradeStation Traders' Tip that was published in
the March 1999 STOCKS & COMMODITIES,
I noticed a small problem in the name that I used for the function. The
name of the function should have been "StochasticCustom." I inadvertently
specified the name as "StochCustom."
Gaston Sanchez
EasyLanguage Specialist
Omega Research
