maximum allowable risk level, which you may not violate under any
circumstances. If your technical analysis stops are closer to the
market, you may hold them in your mind as you monitor prices and are
prepared to exit if those levels gets hit.
Here, I want to share with you two advanced methods for placing stops.
Try to program them into your software and test them on your market
data. Until now, I have never disclosed SafeZone to traders, except to
small groups in Trader's Camps, where I like to share my latest
research. It is my principle not to withhold information from my books.
I write as I trade and maintain my edge not by secrecy but by developing
new methods.
The SafeZone Stop
Once in a trade, where should you put your stop? This is one of the
hardest questions in technical analysis. After answering it, you'll face
an even harder one—when and where to move that stop with the passage of
time. Put a stop too close and it'll get whacked by some meaningless
intraday swing. Put it too far, and you'll have very skimpy protection.
The Parabolic System, described in "Trading for a Living", tried to
tackle this problem by moving stops closer to the market each day,
accelerating whenever a stock or a commodity reached a new extreme. The
trouble with Parabolic was that it kept moving even if the market stayed
flat and often got hit by meaningless noise.
The concept of signal and noise states that the trend is the signal and
the nontrending motion is the noise. A stock or a future may be in an
uptrend or a downtrend, but the noise of its random chop can obscure its
signal. Trading at the right edge is hard because the noise level is
high. I developed SafeZone to trail prices with stops tight enough to
protect capital but remote enough to keep clear of most random fluctuations.
Engineers design filters to suppress noise and allow the signal to come
through. If the trend is the signal, then the countertrend motion is the
noise. When the trend is up, we can define noise as that part of each
day's range that protrudes below the previous day's low. When the trend
is down, we can define noise as that part of each day's range that
protrudes above the previous day's high. SafeZone measures market noise
and places stops at a multiple of noise level away from the market.
We may use the slope of a 22-day EMA to define trend. You need to choose
the length of the lookback period for measuring noise level. It has to
be long enough to track recent behavior but short enough to be relevant
for current trading. A period of 10 to 20 days works well, or we can
make our lookback period 100 days or so if we want to average long-term
market behavior.
If the trend is up, mark all downside penetrations during the lookback
period, add their depths, and divide the sum by the number of
penetrations. This gives you the Average Downside Penetration for the
selected lookback period. It reflects the average level of noise in the
current uptrend. Placing your stop any closer would be self-defeation. E
want to place our stops farther away from the market than the average
level of noise. Multiply the Average Downside Penetration by
coefficient, starting with two, but experiment with higher numbers.
Subtract the result from yesterday's low, and place your stop there. If
today's low is lower than yesterday's, do not move your stop lower since
we are only allowed to raise stops on long positions, not lower them.
Reverse these rules in downtrends. When a 22-day EMA identifies a
downtrend, count all the upside penetrations during the lookback period
and find the Average Upside Penetration. Multiply it by a coefficient,
starting with two. When you go short, place a stop twice the Average
Upside Penetration above the previous day's high. Lower your stop
whenever the market makes a lower high, but never raise it.
I anticipate that SafeZone will be programmed into may software
packages, allowing the traders to control both the lookback period and
the multiplication factor. Until then, you will have to do your own
programming or else track SafeZone manually (See Table 6.1). Be sure to
calculate it separately for uptrends and downtrends.
Here are the rules for calculating the SafeZone using an Excel
spreadsheet. Once you understand how it works, try to program SafeZone
into your technical analysis software and superimpose its signals on the
chart. Compare the numbers from the spreadsheet and the trading
software. They should be identical; otherwise, you have a programming
error. Comparing results from the two software packages helps overcome
pesky programming problems.
Rules for Longs in Uptrends When the trend is up, we calculate SafeZone
on the basis of the lows because their pattern determines stop placement.
1. Obtain at least a month of data for your stock or future in
high-low-close format, as shown in Table 6.1 (lows are in column C
with the first record in row 3).
2. Test whether today's low is lower than yesterday's. Go to cell E4,
enter the formula =IF(C3>C4,C3-C4,0) and copy it down the length
of that column. It measures the depth of the downside penetration
below the previous day's range, and if there is none, it shows zero.
3. Choose the lookback period and summarize all downside penetrations
during the time. Begin with 10 days and later experiment with
other values. Go to cell F13, enter the formula =SUM(E4:E13), and
copy it down the length of that column. It will summarize the
extent of all downside penetrations for the past 10 days.
4. Mark each bar that penetrates below the previous bar. Go to cell
G4, enter the formula =IF(C4<C3,1,0) and copy it down the length
of that column. It will mark each downside penetration with 1 and
no penetration with 0.
5. Count the number of downside penetrations during the lookback
period, in this case 10 days. Go to cell H13, enter the formula
=SUM(G4:G13), and copy it down the length of that column. It will
show how many times in the past 10 days the lows have been violated.
6. Find the Average Downside Penetration by dividing the sum of all
downside penetrations during the lookback period by their number.
Go to cell I13, enter the formula =F13/H13, and copy it down the
length of that column. It will show the Average Downside
Penetration for each day, that is, the normal level of downside
noise in that market.
7. Place your stop for today at a multiple of yesterday's Average
Downside Penetration below yesterday's low. Multiply yesterday's
Average Downside Penetration by a selected coefficient, starting
at 2 but testing as high as 3, and subtract the result from
yesterday's low to obtain today's stop. Go to cell J14, enter the
formula =C13-2*I13, and copy it down the length of that column. It
will place a stop two Average Downside Penetrations below the
latest low. If today's low penetrates yesterday's low by twice the
normal range of noise, we bail out.
8. Refine the formula to prevent it from lowering stops in uptrends.
If the above formula tells us to lower our stops, we simply leave
it at the previous day's level. Go to cell K16, enter formula
=MAX(J14:J16), and copy it down the length of that column. It will
prevent the stop from declining for three days, by which time
either the uptrend resumes or the stops is hit.
Rules for Shorts in Downtrends
When the trend is down, we calculate SafeZone on the basis of the highs
because their pattern determines stop placement.
1. Obtain at least a month of data for your stock or future in
high-low-close format, as shown in Table 6.1 (highs are in column
B with the first record in row 3).
2. Test whether today's high is higher than yesterday's. Go to cell
L4, enter the formula =IF(B3>B4,B3-B4,0) and copy it down the
length of that column. It measures the height of the upside
penetration above the previous day's range, and if there is none,
it shows zero.
3. Choose the lookback period and summarize all upside penetrations
during the time. Begin with 10 days and later experiment with
higher values. Go to cell M13, enter the formula =SUM(L4:L13), and
copy it down the length of that column. It will summarize the
extent of all upside penetrations for the past 10 days.
4. Mark each bar that penetrates above the previous bar. Go to cell
N4, enter the formula =IF(B4<B3,1,0) and copy it down the length
of that column. It will mark each upside penetration with 1 and no
penetration with 0.
5. Count the number of upside penetrations during the lookback
period, in this case 10 days. Go to cell O13, enter the formula
=SUM(N4:N13), and copy it down the length of that column. It will
show how many times in the past 10 days the highs have been violated.
6. Find the Average Upside Penetration by dividing the sum of all
upside penetrations during the lookback period by their number. Go
to cell P13, enter the formula =M13/O13, and copy it down the
length of that column. It will show the Average Upside Penetration
for each day, that is, the normal level of upside noise in that
market.
7. Place your stop for today at a multiple of yesterday's Average
Upside Penetration above yesterday's high. Multiply yesterday's
Average Upside Penetration by a selected coefficient, starting at
2 but testing as high as 3, and add the result from yesterday's
high to obtain today's stop. Go to cell Q14, enter the formula
=B13-2*P13, and copy it down the length of that column. It will
place a stop two Average Upside Penetrations above the latest
high. If today's high penetrates yesterday's high by twice the
normal range of noise, we bail out.
8. Refine the formula to prevent it from raising stops in downtrends.
If the above formula tells us to raise our stops, we simply leave
it at the previous day's level. Go to cell R16, enter formula
=MIN(Q14:Q16), and copy it down the length of that column. It will
prevent the stop from rising for three days, by which time either
the downtrend resumes or the stops is hit.
To use SafeZone with your favorite stock or future during an uptrend,
begin by multiplying the average downside penetration by the factor of
three, and subtracting that from the low of the latest bar. Putting your
stop closer than the average level of noise means asking for trouble,
and even twice the average level is often too close. Once your system
identifies an uptrend, SafeZone starts following prices, getting you out
before the trend reverses. You can see that SafeZone stop as hit at
points A, B, C, and D, catching the bulk of the uptrend and avoiding
downdrafts.
The right edge of the chart illustrates why it is a good idea never to
hold a stock below its SafeZone level. JEC is in a free fall, wiping out
the profits of a month in just two days—a trader using SafeZone cashed
out early in the decline.
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