figure 6.17 Combining stops. Two short positions were entered when the stochastic turned down. the first was exited by a profit stop of 0.5 ticks and the second was exited when the previous days high was broken.

S DEUTSCHE IHH & 57.K 3"/.D STOCHAST 11/23/93 Q

93 16 23 S 07 13 20 27 0 11 18 25 N 08 15 22

Figure 6.17, we decided to sell soon after the 5-day stochastic turned down. It turned on October 13. We then sold on the break of the low of the signal. Our initial stops were placed and we chose to exit our first position at 0.5 ticks in our favor and exit the second position whenever the previous days high was broken. This method enables you to use the best that each stop technique has to offer.

Volatility

Volatility is the trading range of a market. Traders view it to determine whether a market has good profit potential. A volatile market can provide good trading opportunities because of its large wide swings as well as its ability to trend. Less volatile markets tend not to move as quickly and it is harder to take advantage of small swings. Volatility is a double-edged sword. High volatility markets can be very dangerous because tight stops get taken out more frequently as big moves occur often in both directions.

Volatility is very important for stop analysis because you need to be aware of the type of market environment you are in (volatile, nonvolatile). When markets exhibit a high degree of volatility, your stops should be a little wider to compensate for the

Figure 6.18 Determining low volatility. As price formed a classical pennant flag pattern, indicating a potential breakout, volatility shrank from 5 to 1.

H DEUTSCHE Iffl 8 UOLATILITY OPTN OS/27/96 Q

96 28 J 10 17 24 J 08 15 22 29 A 12 19 26 S 09 16 23

wide swings. Perhaps you may decide to trade fewer contracts to control risk better. You may also decide to raise profit objectives because you have a greater chance for the market to move farther. The opposite is true when markets exhibit less volatility: you can use tighter stops and you may consider smaller profit objectives as well. Perhaps you can consider trading more contracts since the risk is less and the stops are tighter.

Volatility is an important consideration when you look at the type of stops to use as well as the placement. Most software packages contain volatility studies that you \ can use. Look at historical volatility for the past several weeks and months to get a feel J for where the volatility of the market has been and is now. Figures 6.18 and 6.19 show two methods of determining when a markets volatility is low. The volatility indicator in Figure 6.18 shows a period of one month wherein volatility has fallen from 5 to 1. Notice how the market is trading between 65.5 and 66.0. Figure 6.19 shows the daily range (high minus low) again during the same time frame. Notice how the markets range is under 0.4 ticks. If you are trading during this time frame, you will want to adjust your strategies (stops, targets, time) to reflect the markets inactivity.

Remember that volatility is a double-edged sword and that there will be times when a market becomes too volatile to trade. The risk in a very volatile market becomes one not worth taking. Sometimes it is better to wait for volatility to fall back before trading again.

Figure 6.19 An inactive market. During the same time window as in the previous figure, the daily trading range indicator hovers below 0.5.

S DEUTSCHE irtl 8 F-range 07/30/96 Q

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J96 A 08 15 22 06 13 20 28 J 10 17 24 J 08 15 22 29

Options

Commodity options can also be used as a stop technique. While it is not within the scope of this chapter to explain how the options market works and how the pricing of options is determined, there are many good books on the topic. Options can be complex, and experienced traders should use this technique.

Options represent the right to sell/buy a futures contract at a predetermined price in the future. The two sets of options are puts and calls. Puts represent the right to sell a futures contract at some predetermined price at the expiration date of the option. For example, an October .6700 Swiss franc put gives the buyer the right to sell a Swiss franc futures position at the strike price of .6700 at expiration in October if the futures market is trading below the strike price. Calls represent the right to buy a futures contract at some predetermined price at the options expiration date.

Whenever a position is initiated, you can look to buy cheap options to protect your position. For example, suppose you decide to buy the Swiss franc at .6700. You can buy a .6600 or .6650 put to protect your position. If the market moves against your contract position, the option will increase in value, thereby offsetting most of the loss incurred by the contract. However, if the market moves in your anticipated