VOLATILITY OF MARKETS AND VOLATILITY OF MOOD
I recently posted something important to the TraderFeed blog. I took two months in the S&P emini futures (ES) marketJanuary and May, 2008and compared the median volatility of half-hour periods within the months. During that period, overall market volatility, as gauged by the VIX, had declined significantly. The question is whether this day-to-day volatility also translated to lower volatility for very short time frame traders.
The results were eye-opening: In January, when the VIX was high, the median 30-minute high-low price range was 0.60 percent. In May, with a lower VIX, the range dwindled to 0.28 percent. In other words, markets were moving half as far for the active day trader in May than January.
Lets think about how that affects traders emotionally. The trader whose perceptions are anchored in January and who anticipates much greater movement in May will place profit targets relatively far away. In the lower volatility environment, the market will not reach those targets in the time frame that is traded. Instead, trades that initially move in the traders favor will reverse and fall well short of expectations. Repeat that experience day after day, week after week, and you can see how frustration would build. Out of that frustration, traders may double up on positions, even as opportunity is drying up. Ive seen traders lose significant sums solely because of this dynamic.
Alternatively, the trader who is calibrated to lower volatility environments will place stops relatively close to entries to manage risk. As markets gain volatility, they will blow through those stopseven as the trade eventually turns out to be right. Once again, the likely emotional result is frustration and potential disruption of trading discipline.
Both of these are excellent and all-too-common examples of how poor trading can be the cause of trading distress. It may look as though frustra
tion is causing the loss of disciplineand to a degree that is truebut an equally important part of the picture is that the failure to adjust to market volatility creates the initial frustration. Any invariant set of rules for stops, targets, and position sizingin other words, rules that dont take market volatility into account and adjust accordinglywill produce wildly different results as market volatility shifts. For that reason, the markets changes in volatility can create emotional volatility. We become reactive to markets, because we dont adjust to what those markets are doing.
Poor trading practicepoor execution, risk management, and trade managementis responsible for much emotional distress. Trading affects our psychology as much as psychology affects our trading.
Personality research suggests that each of us, based on our traits, possess different levels of financial risk tolerance. Our risk appetites are expressed in how we size positions, but also in the markets we trade. When markets move from high to low volatility, they can frustrate the aggressive trader. When they shift from low to high volatility, they become threatening for risk-averse traders. The volatility of markets contributes to volatility of mood because the potential risks and rewards of any given trade change meaningfully. In the example from my blog post, that shift occurred within the span of just a few months.
Note that traders can experience the same problem when they shift from trading one market to anothersuch as moving from trading the S&P 500 market to the oil marketor when they shift from trading one stock to another. Day traders of individual equities will often track stocks on a watch list and move quickly from sector to sector, trading shares with different volatility patterns. Unless they adjust their stops, targets, and position sizes accordingly, they can easily frustrate themselves as trades get stopped out too quickly, fail to hit targets, or produce outsized gains or losses.
Many traders crow about taking a huge profit on a particular trade. All too often, that profit is the result of sizing a volatile position too aggressively. While its nice that the trade resulted in a profit, the reality is that the trade probably represents poorly managed risk. Trading 1,000 shares of a small cap tech firm can be quite different from trading 1,000 shares of a Dow stock, even though their prices might be identical. The higher beta associated with the tech trade will ensure that its profits and losses dwarf those of the large cap trade. That makes for volatile trading results and potential emotional volatility.
Risk and reward are proportional: pursuing large gains inevitably brings large drawdowns. The key to success is trading within your risk tolerance so that swings dont change how you view markets and make decisions.
Do you know the volatility of the market youre trading right now? Have you adjusted your trading to take smaller profits and losses in low volatility ones and larger profits and losses when volatility expands? If youre trading different markets or instruments, do you adjust your expectations for the volatility of these? You wouldnt drive the same on a busy freeway as on one that is wide open; similarly, you dont want to be trading fast markets identically to slow ones.
One strategy that has worked well for me in this regard is to examine the past 20 days of trading and calculate the median high-low price range over different holding periods: 30 minutes, 60 minutes, etc. I also take note of the variability around that median: the range of slowest and busiest markets. With this information, I can accomplish several things:
As the day unfolds, I can gauge whether todays ranges are varying from the 20-day average. That gives me a sense for the emerging volatility of the day that Im trading. This helps me adjust expectations as Im trading. For instance, the S&P e-mini market recently made a 12-point move during the morning. My research told me that this was at the very upper end of recent expectations, a conclusion that kept me from chasing the move and helped me take profits on a short position. When I see that volatility over the past 20 days has been quite modest, I can focus on good execution, place stops closer to entry points, and keep profit targets tight. That has me taking profits more aggressively and opportunistically in low volatility environments, reducing my frustration when moves reverse.
When I see that volatility over the past 20 days is expanding, I can widen my stops, raise my profit targets, adjust my size, and let trades breathe a little more. Not infrequently, the higher volatility environment will be one in which I can set multiple price targets, taking partial profits when the first objective is hit and letting the rest of the position ride for the wider, second target.
Note that whats happening in the above situations is that I am taking control over my trading based on market volatility. Instead of letting market movement (or lack of movement) control me, I am actively adjusting my trading to the days environment. That taking of control is a powerful antidote to trading distress, turning volatility shifts into potential opportunity.
The Excel skills outlined in Chapter 10 will be helpful in your tracking average volume and volatility over past market periods.
As your own trading coach, you want to monitor your mood over time. When you see your mood turn dark and frustrated, you want to examine whether there have been changes in the markets that might account for your emotional shifts. Many times, these will be changes in the volatility of the markets and instruments youre trading. Establish rules to adapt to different volatility environments as a best practice that aids both trading and mood.
If you know the average trading volume for your stock or futures contract at each point of the trading day, you can quickly gauge if days are unfolding as slow, low-volatility days or as busy, higher-volatility days. If you know how current volumes compare to their average levels you can identify when markets are truly breaking out of a range, with large participants jumping aboard the repricing of value. If you can identify markets slowing down as that process unfolds, you can be prepared and pull your trading back accordingly.