As featured in the Herald Sun – Friday 4th November 2016.
By David McCulloch – Market educator and consultant to Share Wealth Systems
In the last two articles I have discussed two fairly simple technical indicators, the moving average to help identify trends, and the ADX to measure trend strength. Technical Analysis opens up a world of indicators that are all effectively based on the same three elements, price, time and volume. Perhaps one of the best indicators in my opinion is the ATR (Average True Range) stop loss indicator. Why? Because it’s simple to use as a trend and momentum indicator all in one. Let me explain.
The ATR of a stock includes the price range and also any gaps that might occur in the price between one period and another. To keep things simple, it’s basically a measure of how much we can expect a stock to move either up or down over a given time frame. When the ATR is used as a trailing stop, we really get to see observe its potential. An ATR trailing stop plotted on a chart will “trail” the stock price as it moves higher. If the price starts to move sideways and new highs are not being created the ATR trailing stop will go flat until one of two things happen, price makes a new high and drags the ATR line upwards once more, or price closes below the line and signals an exit. When the exit signal occurs the ATR trailing stop can then be seen “flipping” and will now be situated above the price. When this occurs, it is a sign that the stock now has much more downward price movement and momentum than previously. Further observation often sees the ATR trailing stop following price lower, until the market chooses otherwise.
A simple entry signal is given when price closes above the 4 ATR trailing stop, using a weekly chart. This is very effective for medium to longer term investors and only requires a quick look each week to see if price is still above its trailing 4 ATR. An exit signal occurs when price closes below the 4 ATR trailing stop line. To add some meat to the bones of this idea, we can use a chart of the DJIA (Dow Jones Industrial average) and make a note of each of the signals for entry and exit all the way back to 1897 which includes Bull, Bear and sideways markets.
During that time there were 49 observed signals, of which 29 were profitable with an average profit of 33%, whilst 20 signals realised losses with an average loss of -9%. (Source: Beyond Charts)
Noticeably, the number of profitable signals is greater than the losing ones, but even more important is the profit factor. The wins are more than 4 times greater on average than the losses and this contributes greatly to the longer term results. As simple as the system is, it also extremely effective for signalling exits well before the large bear markets take hold. In essence this simple indicator can provide a realistic mechanism for timing the market when viewed over the longer term time frames of 20 years or more.
David McCulloch is a market educator and consultant to Share Wealth Systems.