Chandelier Exits, Volatility & SafeZone Stops

Traders adjust their stops, over time, in the direction of the trend, in order to lock in profits. Apart from moving averages, one of the most popular techniques uses Average True Range, developed by Welles Wilder. There are three variations of this technique: 

• Chandelier exits and SafeZone stops, discussed by Alexander Elder in Come Into My Trading Room (2002); and
• Volatility Stops, from Welles Wilder's New Concepts in Technical Trading Systems (1978).

  Chandelier Exits

Chandelier Exits subtract a multiple of Average True Range ("ATR") from the highest high ("HH") for the selected period. The most popular settings use a 22-day period and a multiple of 3.0:

Highest High in last 22 days - 3 * ATR for 22 days

In a down-trend the formula is reversed:

Lowest Low in last 22 days + 3 * ATR for 22 days

• The time period must be long enough to capture the highest point of the recent up-trend: too short and the stops move downward; too long and the high may be taken from a previous down-trend.
• It is not essential to use the same period for up and down trends; down-trends are notoriously faster than up-trends and may benefit from a shorter time period.
• The multiple of 3 may be varied, but most traders settle between 2.5 and 3.0.

Evaluation

My concern with this formula is that stops may move lower during an up-trend, something with which I am not at all comfortable:

1. The time period may be too long or too short to correctly reflect the high point in the latest up-trend (as mentioned earlier); and
2. ATR may increase while the HH remains unchanged.

Incredible Charts Features

Incredible Charts offers a similar option to SafeZone to delay/prevent stops from widening (being lowered during an up-trend, or raised during a down-trend):

• Use the maximum of the last 3,4 or 5 days' stops during an up-trend;
• Use the minimum of the last 3,4 or 5 days' stops during a down-trend.

  Volatility Stops

Welles Wilder's system uses Closing Price (rather than Highs and Lows as in Chandelier exits) and incorporates a stop-and-reverse feature (as with the Parabolic SAR).

• Significant Close ("SIC") represents the highest close in an up-trend and the lowest close in a down-trend.
• The formula bases stops on a multiple of Average True Range ("ATR") for the selected period (normally 7 days).
• Wilder uses a multiple of between 2.8 and 3.1 (we use 3.0 in the explanation below).

Calculate ATR for the selected period and the highest close ( the initial SIC).

The stop for day 8 is:

SIC - 3 * ATR

SIC is increased each time that there is a higher close (SIC).
So stops are raised when there is a higher close or ATR declines.

When the stop is hit, the system reverses and the SIC for the next day is taken as the Close from today (the day that the stop is hit) as it is the lowest close in the trade:

SIC + 3 * ATR

SIC is then decreased each time that there is a lower close (SIC); until the stop is hit and the system reverses.

Evaluation

Using Closing Price rather than highs in an up-trend (or lows in a down-trend) may reduce the volatility of the system and could produce better results but there are two apparent weaknesses:

1. Stops may move lower during an up-trend (or higher during a down-trend) for the same reasons mentioned under Chandelier exits; and
2. SAR assumes that the trend has changed every time that your stop is hit: any trader will tell you that your stops may be hit without the trend changing -- price merely retraces through your stops and then resumes the up-trend, leaving you lagging behind.

Incredible Charts Features

Incredible Charts plots Volatility Stops (Long) and (Short) as separate indicators, without the SAR feature, in a similar fashion to Chandelier Exits, to negate weakness # 2 above. Highest close and lowest close are used in place of the highest high and lowest low, to create a smoother line.

Incredible Charts also offers a similar option to SafeZone to delay/prevent stops from widening (being lowered during an up-trend, or raised during a down-trend):

• Use the maximum of the last 3,4 or 5 days' stops during an up-trend;
• Use the minimum of the last 3,4 or 5 days' stops during a down-trend.

  SafeZone

SafeZone was developed by Alexander Elder to eliminate the "noise" component of a trend and hopefully avoid having stops shaken out by that noise. It uses an Exponential MA (normally 22 days); directional movement similar to the calculation in Directional Movement System; and a selected multiple of between 2 and 3 (we use "2.5" in the explanation below).

Define the Trend

First compare Closing Price to an Exponential Moving Average to define the trend. 

• If Closing Price is above the MA for the selected period, that means that the trend (and the MA slope) is upward.
• If Closing Price is below the MA, the trend is downward.

Directional Movement

The second element is Directional Movement. This is calculated in a similar fashion to DI+ and DI- in the Directional Movement System:

+DM = Today's High - Yesterday's High (when price moves upward)

-DM  = Yesterday's Low - Today's Low (when price moves downward)

The difference is that you can have both +DM and -DM on the same day. If there is an outside day then both calculations will be positive. For an inside day both calculations are zero.

Directional Movement Days

Calculate the number of days with +DM in the selected period; and the number of -DM days. Dr Elder uses the same selected period for Directional Movement as he does for the moving average, but there appears to be no reason why this could not be varied.

When the Trend is UP

Calculate -DM Average:

Sum of -DM for the period / Number of -DM days

Then calculate the Stop Level for today:

Today's Stop = Yesterday's Low - 2.5 * -DM Average

To delay/prevent the stop from being lowered, use the maximum of the last 3 days' stops.

When the Trend is DOWN

Calculate +DM Average:

Sum of +DM for the period / Number of +DM days

Then calculate the Stop Level for today:

Today's Stop = Yesterday's High + 2.5 * +DM Average

To delay/prevent the stop from being raised, take the minimum of the last 3 days' stops.

Evaluation

SafeZone has three advantages:

• Stops cannot move lower during an up-trend (or higher during a down-trend);
• SafeZone does not assume that the trend has changed every time that your stops are hit; and
• SafeZone uses Directional Movement rather than ATR as a measure of volatility. This is an excellent concept. It isolates counter-trend movement as the risk factor when following a trend and removes the other irrelevant component of volatility (movement in the direction of the prevailing trend).

Potential weaknesses:

• SafeZone fails to adequately distinguish between counter-trend movement and movement in the direction of the prevailing trend. All -DM and + DM is treated equally, whether the trend is up or down, giving an incorrect reflection of counter-trend movement. The distortion should not be exaggerated. It will only apply at the start of a trend: if the trend has changed within the selected time period.
• The relatively short time period over which directional movement is calculated may not adequately reflect potential counter-trend movement: a blow-off (or runaway trend as Dr Elder refers to them) may only occur once every several years. And the period leading up to a blow-off, while displaying wide ATR, may show little or no counter-trend movement. This means that stops will move tighter as the trend accelerates into a blow-off -- which may turn out to be an advantage.
• SafeZone relies on an exponential moving average to indicate trend direction. This may introduce some lag. However, there is nothing to stop the trader from substituting another trend indicator in place of the moving average (see below).

Overall, a very clever system.

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