Volatility is at the heart of many trading systems because volatility helps you understand the poten tial risk your trade can be exposed to.
While the subject of Value at Risk is too vast to cover in this article alone, understanding Standard Deviation will help you understand volatility and the likelihood or probability of price traveling outside of historical volatility so that you can gauge strong entries with the trend and place stops with confidence when taking a trade.
The concept of trading with the trend and setting your stop exits based on out of range volatility moves can be visualized through a distribution curve. In short, if price goes outside of 3 standard deviations visualized through the Bollinger Bands with the trend staying in tact, you can look to take a high probability entry off the rejection of that price swing and set your stop closely above your entry.
The chart above shows you entering in the direction of the trend after a counter trend move may have exhausted and price continues with the trend. The Value at Risk concept with the chart above can be seen through the eyes of entering off of a statistically rare event against the trend. Therefore, you can enter with the trend with a high level of confidence because your exit can be set above your entry which was based off a statistically rare event and reduces the likeliness of getting stopped out.
However, ATR is still valuable and can be a simple approach to setting stops but is not useful for entries because it is non-directional. Thinking and trading in terms of probabilities is one of the major forces behind allowing a trader to work a trading system to get the most out of your edge against the market.
Naturally, you want that potential to be as limited as possible which is the purpose of the article. When volatility snaps outside its historical average, that small percentage loss is hit and can result in a large loss. This happened across the board in wake of the credit crisis. Entire financial institutions used VaR to get the most out of their trading desks but they were leveraged up to 40x their book value way above our 5x recommendation and when volatility snapped outside their historical limits, it brought major institutions down.
In the end, this new science of risk management concept is meant to help you confidently understand how much capital i. However, you can use the VaR concept to limit the amount you could lose in a really bad week, month or year by using this concept.
Trading with the trend will always be paramount regardless of the latest and greatest tool or concept in the market. Whether you define risk with the Average True Range, Average True Range multiples, or Bollinger Band Rejections on the chart, you must keep your trade size in control so you have the capital to take the next trade in the direction of the trend. DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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