If we were to take a short trade in EU and set our stop just above the Lower high I've labeled as Price Peak #1, we have a fairly good chance that price will violate that stop before the trade can run to glorious profits. That is to say, price would temporarily travel above that previous Price peak before continuing on it's way along the down trend. The probability that price will violate that previous lower high in price varies depending on the time frame we are looking at volatility of the pair and to a lessor extent other factors, but we won't be able to trail a stop this close many times before price violates the stop. after 3, or 5, or 10 stop trails, price will violate the stop and kick us out of our good trade and we'll give back some profit in the process. We need a better method, but one simple enough we can quickly set and adjust our stops. I like being able to do all my trading calculations in my head, and my head isn't as snappy as it once was, so I want to keep this simple.
Certainly volatility is a big factor here. The more volatile the pair, the more likely we would get kicked out of a good trade early. Many traders use the ATR average true range to account for volatility, but it has some drawbacks. ATR usually averages volatility over some previous number of bars, like 10 or 20 or so. But price volatility cares little for how we count bars. In the example above, volatility was fairly low for the previous 40 bars, then extreme for the 10 bars before that. If you take the average volatility of the previous 10, or 20 or even 40 bars, you'd conclude that a very tight stop would be fine. Even if you average in the volatility of the sharp drop 50 bars ago, the result is still low due to the recent majority of low volatility bars averaging in. We need to account for volatility, but the ATR isn't a good enough measure of recent volatility for our purpose. Discussion, questions, comments?
Certainly volatility is a big factor here. The more volatile the pair, the more likely we would get kicked out of a good trade early. Many traders use the ATR average true range to account for volatility, but it has some drawbacks. ATR usually averages volatility over some previous number of bars, like 10 or 20 or so. But price volatility cares little for how we count bars. In the example above, volatility was fairly low for the previous 40 bars, then extreme for the 10 bars before that. If you take the average volatility of the previous 10, or 20 or even 40 bars, you'd conclude that a very tight stop would be fine. Even if you average in the volatility of the sharp drop 50 bars ago, the result is still low due to the recent majority of low volatility bars averaging in. We need to account for volatility, but the ATR isn't a good enough measure of recent volatility for our purpose. Discussion, questions, comments?