Some Simple Trading Math

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  • on October 29th, 2011

“The trader will be aided by an opinion whether a bull or bear market prevails, but since many of his operations will be the reverse of the trend he cannot confine himself to indications of long trend but must study the causes and indications behind the lesser moves.”  Joseph Kerr, Method in Dealing in Stocks

As traders, we face a constant battle between anticipating and reacting.  Too much of the former, and we risk being early and therefore tired of the ride by the time it gets smooth.  Too much of the latter, and our lateness may be immediately rewarded but on the verge of punishment.  Finding the right mix has been a “forever” pursuit of mine and if anything I’ve survived in spite of lacking the skill.

Then I had a recent “A-ha” moment.  Since Average True Range(ATR) is weaved into everything I track, can’t I use its own range to set some boundaries?  The answer is a resounding “Yes”, and the math is very basic.  I know charting platforms use standard deviation and other types of “bands”, but I’ve often managed to rationalize those bands away or at the least just use them ineffectively.  With ATR, I have a true understanding of not only what I’m measuring but how it fits in my expectancy calculation.  Take a look at the following:

Very simple.  Every 15-30 minutes I plug into B5:D5 the new 78/104/130 period averages on a 15 minute chart, and I have a clear “perspective meter”.  Notice I don’t say prediction meter…there is no magic predictive ability in this measurement(nor any other, for that matter).  But if part of our risk management plan says to carry a 2 ATR stop, can we really afford to start a swing trade a full day’s range above where price has been in the past 3-5 days?

Simply knowing when to be a detached observer and when to go into stalking mode makes a huge difference in avoiding both the financial(chasing) and emotional(anxiety) risks that come with staring at evolving patterns.  If I’m stalking a buy, I’m not even looking until we approach E6(which spits out R:R in cell E1).  Selling a bounce?  G4 is where I start(R:R in G9).  The math is broad yet simple; its use is trader-specific with the following caveats:

1) Swing Bias- Columns E, F, and G: I use 2 of the 3 columns at any moment.  That gives me 2 templates from which to work(Up/Sideways using E and F, or Down/Sideways using F and G).  Notice I exclude -1.0 and -1.5 from Column E(Upswing)…it’s useless info as an upswing doesn’t give you a chance to buy 1 ATR below these averages.

2) Reward:Risk- E1:G1 and E9:G9 calculate near-term reward and risk using only the ATR boundaries.  I like to know where the 2:1 level is, and am not real interested in acting until evolving value “catches up”.  Others may have different parameters.

3) ATR Boundaries- Column A shows some “stretches” I consider worth knowing.  I’ve tracked 400 stocks on a Daily ATR basis for the past couple of years, and it takes a ton of emotion to stretch liquid stocks outside of these boundaries.  Consider Thursday, one of those days where we all were impressed with the move but also thought it a little late to buy.  Even then, only 5 of 400 stocks closed > 2 ATR above all 3 averages…$CRR, $OC, $GS, $MCO, and $ESRX.  $SPY itself closed only 1.36, 1.37, and 1.39 ATR above its 3, 4, & 5 Day averages(chart view below).

What comes out of this is a way of measuring in clear terms just where the current price sits in relation to recent “value”.  I know that’s a subjective term but I’m using it anyway.  After watching Brian Shannon at least weekly for a couple of years, it’s hard to not give some weight to a short-term average in assessing the swing trend.  He always references the 5 day average; I’ve added the 3 and 4 day as my own way of allowing for pivotal turning points that may have occurred more recently but your personality may desire either a faster or slower approach.

The point is that on some level we’re all risking some fraction of a stock’s normal range.  We all have different timeframes and styles and risk parameters, but anything that can help cut the denominator(risk) and increase the numerator(reward) is a win, right?  Who knows, maybe the increased patience gives our win ratio a boost as well.  I’m not using this to daytrade, but starting a long-term trade with a more precise entry can only get us closer to “buy right and sit tight”.

If I knew a way to keep a daily indicator on an intraday chart, I suppose that would be easier.  But in an arena of constant uncertainty, I like the clarity I get in Excel.  It’s an extra step but provides some science to go with what is clearly a game driven by art of shifting perceptions.  And one guarantee I can make is that no matter how extreme we perceive a move to be, the stock or index we’re tracking WILL touch these averages again within a few days.  That alone should bring some sanity when we’re going through an insane moment of fear or regret.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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