Using volatility contraction to increase your profits

Often you see people talking about a winning trade, and how far in percentage terms price moved in their favour after entry.

But on its own, this doesn't tell you anything - to me, it is a worthless metric when evaluating performance.

As a trader, I'm far more interested in the size of the profit (or loss) generated when expressed in terms of R.

As an example, lets take two hypothetical stocks - Stock A moves 500% in your favour after entry, while Stock B advances 'only' 100%.

On the face of it, you may think that Stock A was the better trade. But lets add some additional information - the type which people who brag about big percentage moves typically don't give you:

Stock A gave an entry signal when price hit $20. The 500% move meant that the trade was closed when price reached $120.

What you didn't know is that the initial stop was placed at $10, being $10 from the entry price. Therefore, each unit of R (being the initial risk on the trade) equates to a price movement of $10. 

In this example, price moved $100 in your favour post-entry, meaning that the profit on the trade equated to +10R (the $100 price movement divided by the value of 1 unit of R).

Now lets take Stock B.

In this case, an entry was also triggered at $20, and the 100% price move meant that the trade was closed when the stock was at $40.

The crucial difference here is that the initial stop was placed at $19, a distance of only $1. This means that each unit of R also equated to $1.

As a result of price moving $20 in your favour, trading stock B yielded a profit equivalent to +20R.

Therefore, trading Stock B meant you would have made twice the profit compared to trading Stock A.

Now, as a trader, which would you rather have - the bigger moving stock (in percentage terms), or the trade which yielded the bigger profit?

Secondly, how can you identify more setups like Stock B?

The potential answer comes in looking at how your initial stop distance is calculated, and how you interpret volatility.

Some traders choose to adopt a fixed percentage or price distance as an initial stop, regardless of the level of volatility in the stock or instrument they are looking to trade.

Others however adopt a volatility-based position sizing model, such as using a multiple of Average True Range.

When adopting this model, you are effectively looking for setups where volatility has contracted and / or the ATR reading is at a low level compared to previous weeks, months, or even years!

These types of setups have the benefit of allowing the use of a smaller initial stop distance.

As a result, you are able to have a larger position size, while keeping to the same percentage of equity at risk on the trade.

Should price then move in your favour after entry, it has to move a smaller distance to generate each 'unit' of profit when measured in R.

The examples and explanations above should make it clear it is not how far price moves after entry which solely determines the size of the profit.

In this post I talked about how some of the famous trend followers also identified and used volatility.

Finally, a word of warning.

Wherever there is potential reward, there is also risk. There is an ever-present danger that, by using a very tight stop and a larger position size, a sudden price move or overnight gap can result in an actual loss far greater than the amount you original risked on the trade.

These can be caused by earnings releases, or by unexpected government or central bank announcements - the most extreme example in recent years being the Swiss Franc price movement in early 2015.

Therefore, ensure that you consider and factor in the unexpected when formulating your rules both in terms of your initial stop distance and your overall percentage of equity on each trade.