Wednesday, March 31, 2010

Every Trade Idea Includes Hidden Volatility Assumptions

This will begin a series of short posts on price targets, why they're helpful, and how I calculate them.

While many traders pay close attention to their entries, they don't always crystallize their ideas as to how far the market is likely to move in their direction. Without a clear idea of price targets, it's easy to exit positions too quickly or overstay your welcome and see moves in your favor reverse against you.

Price targets incorporate assumptions not only about directionality, but also volatility. This is where most traders get hung up: they focus on market direction, but their assumptions regarding volatility are hidden--and often inaccurate.

This is a very important concept: every trade idea embeds a hypothesis about *both* direction and volatility. When we calculate the risk and reward on a trade, we're making assumptions about how and how far the market could move in our direction. Bad calls on volatility could be as problematic over time as bad directional calls.

My goal, in part, is to make you more aware, more conscious of your volatility projections when you hold a trade toward a chosen objective or place a stop out point away from your expected direction.

So how can we adjust for volatility? There are two ways, and those will be topics for the next posts in this series.


steve said...

Good timing, I just exited a trade for 1 tick because "it didn't smell right", or at least I made myself think that. Looking for an instant move off entry is an unproductive exercise in instant gratification.

Joe said...

Dr. Brett,

I love this topic already and am intrigued to read the upcoming discussion. I can imagine becoming more aware of ATR to make better decisions about exits based on recent volatility, but I'm anxious what else others use.

Thanks for all you do!

Scott said...

Instant gratification i like to describe as the instant the perceived edge has gone - the reasons for entering the trade are no longer valid - so exit like lighting - this is hard to learn, but it keeps the losers small.

Fitz said...

"how *quickly* and how far..." - or, " *fast* and how far" (which is punchier but less accurate.)

Kishan Bobba said...

With "What Intensity?"
In "Which Direction?"

That is what I always questioned my self.

Dr.Brett waiting for more.

- Bobba Kishan

Daniel said...

"The instant the perceived edge has gone..."

Ah, there's the rub, as the saying goes. Sometimes the perceived edge disappears for a short while, a minor countertrend prevails, then the primary original impetus for the trade renews.

At that point one is happy not to be stopped out; a volatility colored Over-ride signal prevailed. At other times, one is happy for a quick OUT, maximizing the profit which proved available.

Volatility colors the odds of mean regression or trend persistence. This is what Dr. Brett stresses.


TraderScott said...

If this is a question you'll answer in upcoming articles, I'll wait for the answer, but my first thought was-do you mean to use this for trade entry and exit decision making or for position sizing?