Daryl Guppy is founder and Director of Guppytraders.com. He is a full-time active private position trader, trading equities and associated derivatives markets. He is an appointed foundation member of the Australian Government Shareholders and Investors Advisory Council.
He is the developer of the Guppy Multiple Moving Average Indicator included in EzyChart. He delivers accredited courses for the Singapore Stock Exchange. He also runs public trading workshops, and equity and futures brokerage sponsored seminars, throughout Australia and Asia.
PLACING THE CBL STOP
Although charting software like GTE Charting and EzyChart have automatic Count Back Line tools, they still require the users to select the correct calculation point. If you select an inappropriate bar to commence the calculation, the placement of the stop loss lines will be inaccurate - even though they have been calculated according to the rules.
The Count Back Line is calculated from the highest high in the current trend. The count back line is designed to capture the developing ranging activity, or volatility of price. When we use it as a stop loss calculation we work with the most recent highest high in the trend. In the chart extract, taken from the PCH Group Limited chart, the most recent high is shown by the blue check mark.
Moving down from this bar, across to the left to the next lowest bar, and then across to the left again to the third lowest bar gives us a correct CBL stop loss at $0.355.
If we used the first equal high, shown by the red cross, the stop loss calculation is lower at $0.35. The most appropriate definition of the change in volatility is created by the most recent high in the trend. When we have two equal highs, we always use the most recent high as the starting point for the calculation. This ensures that the stop loss does not lag too far behind the current price action. It does not allow the trend to collapse significantly before the stop loss is triggered.
The second question reflected some confusion about the application of the Count Back Line with some readers suggesting that it might be calculated from the higher highs AFTER the day of purchase. This incorrect calculation point is shown by the red cross. The significant feature of the trend is the highest high. For the trend to continue, prices must be able to push above this level and keep on rising.
We expect the trend to pause, consolidate, to ebb and flow. The extent of this ebb and flow is defined by the ranging activity of price - by the volatility of the stock. This volatility changes over time. We have a choice. We can use micro adjustments to reflect changes in volatility. This is the approach used by intraday and short term traders. Calculations such as Deel's Average Dollar Price Volatility or the Tony Oz approach are designed to capture small changes in price over short periods with the intention of running a very tight stop loss. This is an excellent tactic for day trading, but less useful for position trading where we want to participate in a rising tide rather than just capture a rising wave.
An alternative is to use a time-based figure that does not accurately reflect the frequency of changes in volatility. These are Average true range calculations. The user predetermines a set time period, 3, 5, 7, 10 or more days and calculates the average true range - or volatility- for this period. This figure is then applied to the current price action. This is a useful approach, but because the calculation starts with a predetermined time figure - 3 days - it is not always the most appropriate stop loss for the individual stock, or for the type of trend change that is developing.
This is why we prefer to use the Count Back Line. It is built around significant changes in volatility. It takes into account low volatility days when nothing much happens. It factors in days of increased volatility and adjusts the stops accordingly. We find the CBL more responsive to changes in the nature of the trend.
When we combine these two factors - the highest high in the trend, and the ebb and flow within the rising trend - we can see why the CBL calculation is not applied to new highs after we have purchased the stock. The calculation point shown by the red cross is not correct because it does not define the prevailing trend. The calculation that defines the stability and continuation of the current trend starts with the most recent highest high, shown by the blue tick. This calculation sets a volatility-based stop at $0.355. In the chart extract shown, prices could fall back to $0.355 and not threaten the underlying trend. If we used a stop-based on a high after the buy point, we may find ourselves taken out of the trade as prices reach $0.36. The CBL stop has two roles. The first is to protect capital. The second is to define the trend so we do not get shaken out of the trade accidentally. We need to know when we need to run, and a correctly calculated CBL gives us the answer.
This construction logic also tells us when it is appropriate to start a new CBL stop loss calculation. The chart extract shows some additional imaginary bars. The trigger point for a new calculation is when a new high is reached that is higher than the previous high used as a start for the calculation point for the existing count back line. In simple terms, we look at the most recent high. If it is higher than the original high used for the current CBL calculation, then we start a new calculation. It is only when prices rise into the zone for the calculation of a new CBL that we start the new calculation. The starting point is the highs shown by the blue tick. We do not use the close as the trigger point. The close is set by the smart money, but it is the bulls that lead the way in an uptrend. We need to know how far the bulls can push prices, so we use the high as the starting point.
We use the close only when deciding to get out after a stop loss signal has been triggered. We use this because we do not want to be upset by extremes of crowd emotion. Some bearish sellers may drive prices below the count back line during the day. We do not need to panic until the smart money agrees with the bears and closes the price below the stop loss line.
The count back line is a very useful tool for controlling risk because of the way it combines trend definition with volatility monitoring. However, to be effective, the starting point used in the calculation must be accurate and start from the correct high.
First Published: 22 January 2004 - Copyright © Daryl Guppy
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