Monday, October 6, 2008

New Exit Forex Trading Strategy - The ATR Ratchet By Chuck LeBeau

A New Exit Strategy - The ATR Ratchet By Chuck LeBeau

Recently I've been doing quite a bit of research on new systems for
stock trading. The research is on behalf of a new hedge fund that will
be starting later this year. The fund will be managed by Tan LeBeau LLC,
the company that funded this research project. After some serious
internal discussion about the advantages of keeping this new exit
strategy a company secret, the LLC has graciously given me permission to
share this discovery with our System Traders Club members. Here is a bit
of background on how the new exit strategy came about.

In the process of testing various exit strategies for our stock trading
systems we found that we needed a profit-taking exit that performed
somewhat along the lines of the Parabolic SAR but that could be made
more flexible and easier to code and apply. We found that the Parabolic
was hard to use because it was often on the opposite side of the market
from our trades or it was starting from a point that was too low for
what we wanted. After spending a great deal of time with the Parabolic
we decided it was not helpful for the particular systems we were
creating. As an alternative to the Parabolic exit we decided to test
some new exit ideas based on my extensive work and experience with the
Average True Range. After a great deal of tinkering and experimentation
we were pleased to learn that the new exit strategy worked surprisingly
well for profit taking and had many very useful features and
applications. I decided to name this new exit strategy the "ATR Ratchet".

The basic idea is quite simple. We first pick a logical starting point
and then add daily units of ATR to the starting point to produce a
trailing stop that moves consistently higher while also adapting to
changes in volatility. The advantage of this strategy over the original
Parabolic based exit is that when using the ATR Ratchet we have much
more control of the starting point and the acceleration. We also found
that the ATR based exit has a fast and appropriate reaction to changes
in volatility that will enable us to lock in more profit than most
conventional trailing exits.

Here is an example of the strategy: After the trade has reached a profit
target of at least one ATR or more, we pick a recent low point (such as
the lowest low of the last ten days). Then we add some small daily unit
of ATR (0.05 ATR for example) to that low point for each day in the
trade. If we have been in the trade for 15 days we would multiply 0.05
ATRs by 15 days and add the resulting 0.75 ATRs to the starting point.
After 20 days in the trade we would now be adding 1.0 ATRs (.05 times
20) to the lowest low of the last ten days. The ATR Ratchet is very
simple in its logic but you will quickly discover that there are lots of
moving parts that perform a lot of interesting and useful functions;
much more than we expected.

We particularly like this strategy because, unlike the Parabolic, the
ATR Ratchet can easily be implemented any time we want during the trade.
We can start implementing the stop the very first day of the trade or we
can wait until some specific event prompts us to implement a
profit-taking exit. I would suggest waiting to use the exit until some
minimum level of profitability has been reached because, as you will
see, this stop has a way of moving up very rapidly under favorable
market conditions.

The ATR Ratchet begins very quietly and moves up steadily each day
because we are adding one small unit of ATR for each bar in the trade.
However the starting point from which the stop is being calculated (the
10 day low in our example) also moves up on a regular basis as long as
the market is headed in the right direction. So now we have a constantly
increasing number of units of ATR being added to a constantly rising ten
day low. Each time the 10-day low increases our ATR Ratchet moves higher
so we typically have a small but steady increase in the daily stop
followed by much larger jumps as the 10 day low moves higher. It is
important to emphasize that we are constantly adding our daily
acceleration to an upward moving starting point that produces a unique
dual acceleration feature for this exit. We have a rising stop that is
being accelerated by both time and price. In addition, the ATR Ratchet
will often add substantial additional acceleration in response to
increases in volatility during the trade.

The acceleration due to range expansions is an important feature of the
ATR Ratchet. Because markets often tend to show wider ranges as the
trend accelerates the ATR will tend to expand very rapidly during our
best profit runs. In a fast moving market you will typically find many
gaps and large range bars. Because we are adding multiple units of ATR
to our starting point, any increase in the size of the underlying ATR
causes the stop to suddenly make a very large jump that brings it closer
to the high point of the trade. If we have been in the trade for forty
days any increase in the ATR will have a forty-fold impact on the
cumulative daily acceleration. That is exactly what we want it to do. We
found that when a market was making a good profit run the ATR Ratchet
moved up surprisingly fast and did an excellent job of locking in open

Keep in mind that this exit strategy is a new one (even to us) so our
experience and observations about it are still very limited. However I
am going to discuss a few observations about the variables that might
help you to understand and apply this exit successfully.

Starting Price: One of the nice features about the ATR Ratchet is that
we can start it any place we want. For example we can start it at some
significant low point just as the Parabolic does. Or we can start it at
a swing low, a support level, and a channel low or at our entry point
minus some ATR unit. If we wait until the trade is fairly profitable we
could start it at the entry point or even somewhere above our entry
point. The possible starting points are unlimited; use your imagination
and your logic to find a starting point that makes sense for your time
frame and for what you want your system to accomplish. Our idea of
starting the Ratchet from the x day low makes it move up faster than a
fixed starting point (as in the Parabolic) because the starting point
rises repeatedly in a strong market. If you prefer, you could just as
easily start the Ratchet at something like 2 ATRs below the entry price
and then the starting point would remain fixed. In this case the Ratchet
would move up only as the result of accumulating additional time in the
trade and as the result of possible expansions of the ATR itself.

When to Start: We can very easily initiate the exit strategy based on
time rather than price or combine the two ideas. For example, we can
start the exit only after the trade has been open for at least 10 days
and is profitable by more than one ATR. My general impression at this
point is that it is best to implement the ATR Ratchet only after a
fairly large profit objective has been reached. The ATR Ratchet looks
like a very good profit taking exit but I suspect it will kick you out
of a trade much too soon if you start it before the trade is profitable.

As I mentioned, one of the things I like best about the ATR Ratchet is
its flexibility and adaptability. Here is another idea on how to start
it. We can start it after fifteen bars but we don't necessarily have to
add fifteen ratchets. The logic for the coding would be to start the
Ratchet after 15 bars in the trade but multiply the ATR units by the
number of bars in the trade minus ten or divide the number of days in
the trade by some constant before multiplying the ATR units. This
procedure will reduce the number of ratchets, particularly at the
beginning of the trade when the exit is first implemented. Play around
with the ATR Ratchet and see what creative ideas you can come up with.

Daily Ratchet Amount: After testing it the daily Ratchet amount we chose
when we were first doing our research turned out to be much too large
for our intended application. The large Ratchet amount (percentage of
ATR) moved the stop up too fast for the time frame we wanted to trade.
After some trial and error we found that a Ratchet amount in the
neighborhood of 0.05 or 0.10 (5% or 10% of one 20-day average true
range) multiplied by the number of bars the trade has been open will
move the stop up much faster than you might expect.

As a variation on this strategy the very small initial Ratchet can
always be increased later in the trade once the profits are very high.
We could start with a small Ratchet and then after a large amount of
profit we could use a larger daily Ratchet increment. There are all
sorts of interesting possibilities.

ATR Length: As we have learned in our previous uses of ATR, the length
that we use to average the ranges can be very important. If we want the
ATR to be highly responsive to short term variations in the size of the
range we should use a short length for the average (4 or 5 bars). If we
want a smoother ATR with less reaction to one or two days of unusual
volatility we should use a longer average (20 to 50 bars). For most of
my work with the ATR I use 20 days for the average unless I have a good
reason to make it more or less sensitive.

Summary: We have just scratched the surface on our understanding of the
possibilities and variations of the ATR Ratchet as a profit taking tool.
We particularly like the flexibility it offers and we suspect that each
trader will wind up using a slightly different variation. As you can
see, there are many important variables to tinker with. Be sure to code
the Ratchet so it gets plotted on a chart when your are first learning
and experimenting with it. The ATR Ratchet is full of pleasant surprises
and the plot on the chart will quickly teach you a great deal about its
unusual characteristics.

Be sure to let us know if you come up with any exciting ideas on how to
apply it.

Good luck and good trading.

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