Volatility Stops

Notes:

These indicators and concepts are specifically designed for TradingView.com

Overview

Volatility Stops is a popular technical analysis indicator used in trading to help traders identify when to enter and exit trades. It is based on the concept that the volatility of an asset can help traders determine the appropriate placement of stop-loss orders. Volatility Stops works by adjusting the stop-loss order based on the level of volatility in the market.

How to trade Volatility Stops

Volatility stops are calculated using the Average True Range (ATR) indicator, which measures the average range of price movement over a given period of time. The ATR is then multiplied by a factor to determine the distance of the stop-loss order from the current market price. The factor used to calculate the distance of the stop-loss order can be adjusted to account for different levels of risk tolerance. As the level of volatility in the market changes, the distance of the stop-loss order is adjusted accordingly. In periods of high volatility, the stop-loss order is moved further away from the current market price, to prevent the trade from being stopped out prematurely. In periods of low volatility, the stop-loss order is moved closer to the current market price, to reduce the risk of loss if the market suddenly moves against the position. Volatility stops can be used in combination with other technical analysis indicators to identify potential entry and exit points in the market. For example, traders may use the Relative Strength Index (RSI) to identify overbought or oversold conditions, and use the volatility stop to set the appropriate level of risk for the trade.

Here is a step by step guide:

1. Calculate the Average True Range (ATR): The first step in using Volatility Stops is to calculate the ATR. The ATR measures the average range of an asset over a specific period of time, taking into account any gaps in price. A common period for the ATR calculation is 14 days, but this can be adjusted to suit the trader's preference.
2. Calculate the Volatility Stop: Once the ATR is calculated, the next step is to calculate the Volatility Stop. The Volatility Stop is a level that is plotted on the chart and represents the stop-loss order. It is calculated by adding or subtracting a multiple of the ATR from the current price. The multiple used depends on the trader's preference, but a common value is 2 or 3 times the ATR.
3. Place the stop-loss order: Once the Volatility Stop is calculated, traders can place their stop-loss orders at this level. The stop-loss order is used to limit potential losses in the event that the trade goes against the trader.
4. Adjust the stop-loss order: As the price of the asset moves, the Volatility Stop will also move. If the price of the asset moves in favor of the trade, traders can adjust their stop-loss order to the new Volatility Stop level. This allows traders to lock in profits and limit potential losses.
5. Exit the trade: If the Volatility Stop is hit, it is a signal to exit the trade. Traders should exit the trade and look for new opportunities.

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How to Calculate

1. Calculate the Average True Range (ATR) of the asset: The ATR is a measure of volatility that takes into account the range of price movements over a given period. The ATR is calculated by taking the average of the true ranges over a set period, typically 14 days.
2. Determine the multiplier: The multiplier is a factor that is applied to the ATR to determine the distance of the stop level from the asset's price. The multiplier is typically set between 2 and 4.
3. Calculate the stop level: The stop level is calculated by multiplying the ATR by the multiplier and adding or subtracting the result from the asset's price. If the price is rising, the stop level is calculated by subtracting the product of the ATR and the multiplier from the asset's price. If the price is falling, the stop level is calculated by adding the product of the ATR and the multiplier to the asset's price.

For example, let's say that the ATR of an asset is 2.50 and the multiplier is set to 3.0. If the asset is trading at $50 and the price is rising, the stop level would be calculated as follows:

Stop level = $50 - (2.50 x 3.0) = $42.50

In this example, the stop level would be set at $42.50, which represents 3 times the ATR subtracted from the asset's price.

The stop level is adjusted every time the ATR changes. This means that if the volatility of the asset increases, the stop level will move further away from the asset's price to account for the larger price movements. Conversely, if the volatility of the asset decreases, the stop level will move closer to the asset's price to protect profits.

Volatility stops are particularly useful in volatile markets where price movements can be unpredictable. By adjusting the stop level based on the asset's volatility, traders can limit their losses and protect their profits, even in turbulent market conditions.