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Here’s a volatility indicator, presented here with simple trend rules for trading various markets.

New traders quickly become familar with two adages: “The trend is your friend,” and “Let your profits run and cut your losses.” Many of us, however, have learned the hard way that these things are easier said than done. Why is that? One reason is lack of recognition, since the trend itself is rarely clarified and defined, let alone where it starts and ends. So we need a clear explication of what a trend is as well as where its beginning and its end are.

SIMPLE ENOUGH

Simply, if the trend is considered up, then the trend of prices are composed of upwaves and the downwaves are countertrend movements. Downward trends are the opposite, seen as downwaves with countertrend upwaves. Using several tools and functions, we can design a quantifiable approach to defining these waves. My favorite is the volatility indicator, which is a formula that measures the market volatility by plotting a smoothed average of the true range. The true range indicator originates from the work of J. Welles Wilder Jr. from his New Concepts in Technical Trading Systems. The definition of the true range is defined as the largest of the following:

• The difference between today’s high and today’s low
• The difference between today’s high and yesterday’s close, or
• The difference between today’s low and yesterday’s close.

The calculation uses a 21-period weighted average of the true range, giving higher weight to the true range of the most recent bar. The final value is then multiplied by 3.

The volatility indicator is used as a stop-and-reverse method. Let’s say the market has been rising, then the volatility indicator is calculated each day and subtracted from the highest close during the rising market. The highest close is always used, even if there has been a series of lower closes since the highest close. If the market closes below the volatility indicator, then for the next day, the current reading of the volatility indicator is added to the lowest close. This step is followed each day until the market closes above the trailing volatility indicator.

We now have a definition of the trend. An upward trend exists as long as the volatility indicator is below the market and a downtrend is in force if the volatility indicator is above the market. To visualize these waves, we color-code the uptrends blue and the downtrends red (Figures 1 and 2).

In addition, we can add a basic description of trends for trading. We will say that uptrends are made up of waves of higher highs, with prior lows not being surpassed. Conversely, downtrends are composed of waves of lower lows and prior highs not being surpassed. For sustained moves, the upwaves during uptrends will be larger than the countertrend downwaves, and in downtrends, the downwaves will be larger than the countertrend upwaves. Therefore, we want to only trade with the trend and buy upwaves in an uptrend and sell short during a downtrend.

For example, as can seen in Figure 1, for Chase Manhattan Bank, the upwave has higher highs and the prior downwave was not surpassed, so the market is in an uptrend; look to buy only the upwaves. In Figure 2, in the corn market, the opposite situation exists and the same concept is applied, except in this case, the concept is in reverse because it is a downtrend. During November, the volatility indicator reversed trend, and the prior low was broken. This was our signal to go short. Our exit signal will be the volatility indicator turning positive.

The position was closed in January 1998, and since the rally’s high beginning in January did not surpass the highs of October, our second definition of an uptrend was not met. As a result, we went short again when the volatility indicator went negative. In March, the position was closed with a small loss, and again, the highs of this upwave did not surpass the highs of January, so we had a signal to go short again when the volatility indicator went negative and the lows of February were broken.