by Russell Sands
N is a measure of market volatility. It is the average daily range of the last fifteen days. To arrive at this figure, first determine each day’s true daily range (high to low, plus gaps), then add up all these values for the last fifteen days, and divide this sum by fifteen. N is used for three different functions. First and most importantly is to tell us how many contracts will make up one ‘unit’ in any different market. Secondly, N is used to establish a protective absolute hard stop loss point. And finally, N is used subjectively to determine where to add contracts and to estimate the time extent of trading ranges.
Using N to determine the number of contracts is done by first determining what 1% of your bankroll is. If your trading account is $100,000, then we know 1% represents $1,000. Next, convert N (the fifteen day range) into a dollar amount by multiplying the range times the tick value size for the market. For example, in Soybeans if the average fifteen day range is 10 cents, multiply this by the point value ($30 per cent) and you will find that a 1 N move in Soybeans thus is worth $500.
Now divide the N dollar amount into 1% of your equity in order to determine the number of contracts you can trade. In the above example, $1,000 / $500 = 2 contracts (10 bushels at CBT). If the market was less volatile and the N was only 5 cents in Beans, then a 1 N move would be worth $230, and you could trade four contracts (per unit) in a $100,000 account. If your account size is smaller, let’s say $23,000, then with an N of 10 cents you would only be able to trade half a contract per unit (1% of your account is $230, and 1 N (at 10 cents) is $500, so $250 / $500 = ½ contract. This does not mean that your capital is too small to trade a contract of Beans, it simply means that whenever you buy one contract (5m bushels) you must realize that this will be equivalent to a two unit position for you.
In order to use N to determine a hard stop loss point on every trade, keep in mind that we never wish to lose more than 2% of our money on any given trade (per unit of course). Thus, we subtract 2 N from the point of entry on any and every trade, and this is our protective worst case stop loss. This will be 2 N below a long trade or 2 N above a short trade. Remember that we always go flat at these points, and we never reverse. When doing this calculation, simply think of N as the fifteen day daily range. If it’s 10 cents in Beans, then our stop loss will be placed 20 cents away from the point of entry. This will cause a 2% loss of capital. However, if you only have a small account, where you are supposed to trade ½ contract per unit, and thus one contract is equal to a two unit position, then taking a 2 N loss on a trade is going to cost you 4% of your money. (This would happen to any account size if they had a two unit position on.)
The ½ N Whipsaw
The Whipsaw is first of all, a tactic and not a complete strategy. It should be used no more than half of the time, and then should only be used around structural points, i.e. fresh breakouts and possible breakout failures.
The whole point of doing a whipsaw is to keep losses to a minimum. The only way to keep losses small is to take small losses. This is precisely what the whipsaw technique attempts to accomplish.
By taking a ½ N loss instead of a 2 N loss, you can get whipped up to four times before it costs you as much had you stayed with the position originally. Also, barring commission costs, this allows you to take four trades instead of one, which increases your sample size and allows you to get into ‘the long run’ faster, where the laws of probability work in your favor.
For example, in December Cocoa, the lowest low of the past ten weeks had previously been around 985 (on 7/20). On Wednesday, September 16th, Cocoa gapped lower through the breakout on the opening at about 978, but then proceeded to trade straight up. One strategy would have been to wait and see the opening range established, and then put a stop below the low of that range. However, at least one person I know put in an order to sell at the market as soon as he saw the opening point. This was perhaps a little hasty, but by no means incorrect.
He not only got filled at the low of the day, but by the time he got the fill reported back, the market was ten points against him, and it clearly looked like the breakout was going to fail. My friend decided to take a whipsaw and wound up getting out of the trade a few minutes later with about a fifteen tick loss. Cocoa then went straight up for the rest of the day and got as high as 1050, shaking out all the stubborn traders who sold the opening and held on, before collapsing to close at 1006, only a few ticks higher on the day.
However, during the middle of the day, when the market was near its highs, my friend called me to tell me how glad he was that he had taken that small quick loss, because otherwise he would have been feeling a lot more pain. The next day Cocoa went lower again, and he initiated a new short position. We had no idea if this time would work or not, but as far as the last time was concerned, correctly taking the whipsaw saved an extra 1 and ½ N of price and capital.