The Holy Grail Indicator

Now that we have a Point Of Initiation, we can calculate the actual BREAKOUT LEVEL by adding or subtracting the component I call SPACE.

This step is extremely simple. We do it with what I call the Holy Grail Indicator.

But first, a story — because it explains how I found it.

What did I buy on the Russian black market?

After the Velvet Revolution in 1989, when we finally became independent from the Soviet Union and the USSR started falling apart, many Russians took advantage of the chaos. To me it looked like total anarchy.

Between 1989 and 1991, during the Soviet collapse, the Russian black market was having an incredible time. You could buy the most unbelievable things there — including missiles and nuclear submarines. No kidding; a famous Czech reporter made a shocking documentary about it. That was completely normal at that crazy time.

The tradition continues today. It just moved to the internet.

Now, a confession I’m not proud of, but I’m still glad I did it.

During my search for the truth about what actually works in markets, I turned to that Russian black market for help.

I found a Russian who claimed to have source codes for a few highly profitable strategies available for lease. I was intrigued. So I sent $300 to who-knows-where — the payment instructions were crazy — and assumed I’d just been scammed.

The hard drive arrived. Loads of trading software, codes, and the promised strategies, fully revealed.

I felt a mix of deep guilt and childish joy, and I immediately started deconstructing everything.

And I learned a lot.

What did the stolen strategies have in common?

First surprise: they were basic. Nothing fancy, nothing complex, nothing non-standard. The simplicity shocked me.

Second, and this is the part that changed my trading:

All of them had some kind of volatility component.

Every single one used the ATR (Average True Range) or TR (True Range) indicator as its most important element.

Very quickly I realized: this is the truly magic indicator.

Why is ATR the holy grail indicator?

Think about what traders complain about constantly.

Volatility.

It’s never right. Either it’s too high or too low. Too choppy or too crazy. Too sudden or too boring. Traders are never happy with volatility, because it changes all the time. And that makes traders insecure — including me.

Algo traders love fixed, statistically stable constants. Volatility is not fixed.

So how do we solve this?

Very easily. You make volatility a key part of your trading strategy.

At least some parts of your strategy should always reflect current volatility.

That was the discovery my $300 investment bought me. It solved the SPACE component and gave me the best way to calculate the optimal breakout level.

How do you calculate the breakout level?

The recipe is four steps:

1. Take a Point Of Initiation of your own choice.
2. Add volatility to it to calculate the LONG BREAKOUT LEVEL.
3. Subtract volatility from it to calculate the SHORT BREAKOUT LEVEL.
4. Do all of this using the Average True Range indicator — the holy grail indicator.

Here’s what that does for you in practice:

1. When there’s low volatility, your breakout entry levels sit closer to the actual market price. Which is exactly what you want.
2. When there’s high volatility, your entries are set further away from current price, to avoid dangerous and expensive whipsaws.

Think about why that’s correct.

In a low volatility market, you don’t want your breakout level far from the current price. If it is, you won’t capture enough movement to make a reasonable profit and keep your Reward/Risk Ratio positive.

In a high volatility market, you want your breakout level further away, otherwise you get stopped out too often.

The level adapts itself. You don’t have to.

What is FRACT?

Here’s the rule that ties it together:

The SPACE component will always be some multiple of current volatility, which we call FRACT.

(For reference: I sometimes call SPACE “distance”. Same thing, two words for the same component of the formula.)

In coding practice:

LONG BREAKOUT ENTRY LEVEL  = POI + (AverageTrueRange(25) * FRACT)
SHORT BREAKOUT ENTRY LEVEL = POI - (AverageTrueRange(25) * FRACT)

The FRACT will need to be optimized — more on optimization in the next chapters.

For the ATR period itself, we usually use 5, 25, or 40 in our hedge fund. There’s no need to optimize these. You want to keep the number of your optimization inputs limited, and this is one easy place to save a slot.

Do you need to get more creative with SPACE?

No.

That’s an unusual answer from me, because I push creativity everywhere else in this formula. But not here.

This is the easiest, most universal, and most powerful way I’ve ever found to calculate SPACE. Adaptive, adjusting perfectly to the latest volatility changes, doing exactly what I expect it to do.

It just works. It has worked for decades. I’m very sure it will keep working.

So now you have a POI, you have SPACE, and you can calculate actual breakout levels.

Next: filters. And specifically, how many.