strategies

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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.