My Own Volatility Stop

Whew, I've had a crazy couple of days. I managed to catch a couple of counter-trends in the Eur/Usd pair and I watched my account equity expand very rapidly. And it was about the time that I started feeling invincible in my trading that I got caught in some very choppy sideways moves. Man those are frustrating because you see a good profit on a trade and then it reverses on a dime and the trade gets closed out for a loss. That's just the nature of trend following.

These things shouldn't shake me because I've been using an automated trading system, however, I have the system set to where it does not trade in counter-trend rallies and we've mostly had counter-trend rallies (at least how my system defines them) over the past couple of days in the Eur/Usd currency pair. Thus I've been manually trading for the past 2-3 days. There have been some HUGE rallies lately and just catching small pieces of the moves has been very profitable. Needless to say, I've ended the past few days up quite a bit but it still hurts that a small chunk was returned to the market to pay off the trend-following tax gods. Just a part of following trends.

I credit a lot of the success over the past few days to a new stop that I've recently developed and have been implementing for the first real-time trial run. It's a volatility stop that uses a couple of standard deviation lines of a custom momentum oscillator to exit the trade. The idea for this stop came from a trade that I recently made; I bought a currency pair on a squeeze trade and then sold after a quick gain. The problem was that the currency pair continued to move up by 150-200 pips after I sold...which is leaving a lot on the table. This is when I realized that I did not have a good exit signal for the squeeze trade, which is a manual trade as of now, so its not part of the automated system. I needed an exit indicator that could let a position run but also get me out very quickly when momentum dissipates. Thus my standard deviation volatility stop was born.

Here's a chart of a recent trade. The latest purple down arrow was my entry signal to sell the Eur/Usd pair. The top indicator window is the volatility stop indicator (it looks like a MACD but it doesn't work like a MACD at all). The indicator consists of a momentum histogram with a couple of standard deviation overlays. The premise of the stop is that I'm trading quick breakouts that have lots of momentum and the standard deviation lines alert me to reduced short term volatility that tells me the momentum is waning. It doesn't get me out at the absolute top or bottom but it generally catches most of the move and allows for a decent profit. You can see from the chart above that the green standard deviation is above the purple line. The green line is a shorter period line than the purple, which indicates more immediate volatility/momentum. I look for the shorter line (green) to be above the long line (purple) when I enter the trade; this indicates that volatility is rising. Then I exit when the short line crosses the long line, which indicates that momentum is declining from lowering volatility. See the chart below. It's a screen shot from when I closed the trade 21 minutes after the above chart that shows my entry. Notice that the short line (green) crossed the long line (purple). That's when I exited and it was an excellent exit.

Just thought I'd share this idea with hopes that it might help someone out with their own trading. I'm certainly not saying it's the absolute best exit because it does have some glitches and I've had to develope other rules to accomadate those issues. That will make a great post for some future date, although, let me just say that the momentum histogram has a lot to do with making up for the flaws in the standard deviation stop. My next step is to automate and fully test this stop, I'll let you know when it happens and what the results are.

Good luck out there.

TLT