Channel Breakout System with Inside Volatility Barrier

In the previous section we saw the effects of a 20-tick barrier that was outside the 20-day price range. The barrier widened the 20-day price range, and helped to filter out some trades. In the case of the Eurodollar market, the 20-tick barrier was much wider than the normal volatility of that market. Hence, the 20-tick barrier allowed only ten trades to pass through, reducing profits and trading opportunities.

This section will show you how to set up a volatility-based barrier. In an interesting twist, we will set the barrier inside the 20-day price channel (see Figure 5.7). We will have more trading opportunities be­cause the channel will be narrower. The width of the barrier acts as a filter that cuts off trades. You should understand the interaction between volatility and channel width very clearly. If the volatility is low, then the relative channel width will widen. However, if the volatility is high, the actual channel width will be narrower. As volatility increases this system will trade more frequently.

Volatility is defined here as the 10-day SMA of the daily trading range. The daily trading range is simply the difference between today's high and low. Thus, the upper inside barrier is the highest 20-day high minus the volatility. Similarly, the lower inside barrier is the lowest 20-day low plus the volatility. We will go long on the close if it is above the upper inside barrier, and sell on the close if the market closes below the lower inside barrier. The volatility exit is at three times the 10-day SMA of the daily trading range.

Figure 5.8 shows a more detailed view of how the inside barrier works. The actual width of the barrier is narrower, but the width changes every day. The number of trades increases with an inside barrier because the width is narrower than the 20-day channel. Figure 5.8 shows

160 Developing Trading System Variations

-120*10 -118*24 -117*06 -115*20.114*02 -112*16 -110*30 -109*12 -107*26

Oct

Nov

dk

Figure 5.7 The inside volatility barrier superimposed on the 20-day channel shows a long trade in the December 1995 U.S. bond market.

that during narrow consolidations the inside barriers can come close to­gether, or even cross each other. As the inside barriers come close together, the number of trades increases. Thus, the inside barrier system can produce several whipsaw trades in a region of price consolidation.

Figure 5.8 The inside volatility barriers come close together during consolida­tions, increasing trading frequency.

Statistical Significance of Channel Breakout Variations 161

Table 5.7 Results for 20-day channel break out system with inside volatility barrier and volatility exit

Market	Profit (S)	Number of Trades	Percent­age of Wins	Win/ Loss Ratio	Average Trade ($)	Maximum Intraday Draw­down (S)	Profit Factor
British	49,394			2.01		-27,719	1.20
pound
Coffee	235,774			2.58		-29,451	1.79
Cotton	21,050			2.31		-18,395	1.13
Crude oil	-57,300			1.11	-230	-57,720	0.52
Deutsche	48,700			2.12		-14,213	1.34
mark
Eurodollar	26,975			2.25		-6,600	1.55
Gold	47,900			2.91		-23,620	1.34
Japanese	63,588			2.56		-19,550	1.36
yen
U.S.	28,875			2.19		-22,875	1.15
bond
Wheat	-17,638			1.73	-63	-30,719	0.81
Total	447,318
Average	44,732			2.18		-25,086	1.22

You may dislike the increased frequency in consolidations caused by an inside barrier system. One of the strengths of the usual channel break­out system is that it tends to produce fewer trades during price conges­tions. Hence, the inside barrier system will not appeal to all traders.

Table 5.7 shows a summary of testing over previous market data. You will notice that the total profits are up 35 percent versus the fixed 20-tick barrier with volatility exit (compare Table 5.4). The total number of trades has more than doubled to 294 over the fixed 20-tick barrier. The higher trading frequency may be attractive to you if your trading costs are low.