Friday, August 14, 2009

Tempering Trading Expectations: Understanding Stock Market Volatility

I've written about this topic in the past; please check out the post from July. Volatility continues to come out of this market, after the elevated levels we saw late in 2008 and early in 2009. In many ways, the theme of recent markets has been "return to normality": we see a return of normal levels in the LIBOR-OIS spread, a return to more normal levels in the VIX, a return of more normal levels in credit spreads, and a return of more typical daily volatility in the stock market. That's not to say that all is well in the economy; clearly problems in debt levels, housing, and unemployment remain. Rather, financial markets have been recovering from panic levels of pricing.

If we look at the median monthly level of high-low range in the S&P 500 Index (SPY), we find that the current level is almost 25% below the level from just July 1st and over 40% lower than at the start of May. In the last three weeks, only one day has displayed a high-low trading range of greater than 2%; none have moved more than 2.5%.

What that means is that, if the current day's volume is running close to levels of the past several weeks and no major news is roiling currency, interest rate, and/or commodity markets, the odds that we'll see a "big day"--up or down--are quite small.

Indeed, we can quantify what a "big day" might look like with the pivot-derived profit targets that I post for SPY (see the latest update as posted to Twitter). The pivot level represents an estimate of yesterday's average trading price. Only about 15% of trading days move to the R3 resistance level, and only about 15% move to the S3 support level, going back to 2000. Those levels, as I calculate them, are volatility adjusted, so they take into account the shifts in volatility described above.

At this point, it would only take a move of over a little more than 1% from the pivot to generate a "big" R3 or S3 day. That means that about 70% of all days can be expected to trade within a little more than 1% from the pivot. If volume is running light on a light news day, we can pretty much hang our hat on staying within that band.

Knowing that is very helpful in tempering our expectations for how far a move might run during the day. It is also helpful in gauging when the market has moved about as far as we might expect, so that we can take profits.

Knowing how much markets are moving *at your typical holding period* is one of the most useful pieces of information you can use in setting targets and stop losses. Many traders anchor their expectations to past levels of volatility, overstay their welcome in low volatility markets, and give back gains as a result. If you have seen profitable trades reverse on you, there is a real possibility that this is an important reason why.