Monday, March 10, 2014

Adapting to Market Change When Trends Aren't Your Friends

Here is a chart of the average true range for the stock market on a rolling 100-day basis going back to 1997.  What you can see is that volatility has been all over the place.  Anyone in 2012 who counted on markets moving similarly to the prior several years has been severely disappointed.  Indeed, the current 100-day average true range is .88%, just a little over half the median level seen since 1997.  For directional traders, that means that moves on any time frame are extending far less than they have historically.  

So let's say that a trader waits for price confirmation (i.e., for prices to move in the desired direction) prior to entering a position.  Because moves extend less in a low-volatility environment, this means that going long on strength or going short on weakness (or adding to long positions on strength or adding to shorts on weakness) will give trades a particularly short half-life of profitability.  By the time the trader has gained confidence in the move, it's ready to reverse.  How frustrating is that?

Since 2009, we've gained a little over 100 points in SPY.  It's been quite a bull run, as the index has more than doubled.  If we separate next-day returns based upon prior five-day returns, then we can see that only a little more than 13 points of the total move followed the strongest half of five-day periods.  The remaining 88 points--nearly 90% of the total bull move--occurred following the weakest half of five-day periods.

In a low volatility regime, the short-term trend is not necessarily your friend.  It was great being a momentum trader in the late 1990s and many short-term traders I worked with did well during the volatility spike around 2008.  It's been harder for those traders from 2013 forward.  

How do you figure out what works in a more mean-reverting regime?  Studying your successful trades can provide a valuable clue.  It may be the case that you don't need to remake yourself.  Rather, the challenge might be to simply stop doing the things that no longer work.  Reverse engineering your best trades and isolating what makes them work can provide the best coaching of all.

Further Reading:  Stock Market Trends are Not Your Friends


Andrea Casalotti said...

".Because moves extend less in a low-volatility environment"
Are you sure about this?
Long bull runs are generally characterised by low average daily volatility, as 2005, 2006,2013 have shown.
My guess is that traders who did well in 2008 were not momentum traders but very good short term swing traders. In that golden period, everyday one was offered 10-20 great opportunities to make 7+ points, compared to 1-2 today.

David Ayer said...

Overall changes in volatility in the stock market means traders can exploit multiple trading systems. But even in a low volatility market high volatility days occur and there are always high volatility stocks.

Also there are ways we can take advantage of recent volatility, such as incorporating it into each trading system. Position sizing, loss exits, and profit exits can all be based on volatility. For example a high probability short term swing system that enters at the current price, uses a loss exit of .75 Atrs, a profit exit of 1.5 Atrs, and position sizing calculated using the current price and the loss exit (see

- David Ayer

Brett Steenbarger, Ph.D. said...

Thanks for your observation, Andrea. You are correct: longer-term bull markets have been characterized by lower volatility. The important distinction is between trend/momentum on short and longer time frames. As you point out, it's the momentum on the short time frame that made people money in 2008. Patterns can be (and often are) very different on longer and shorter time frames--


Trin said...

In my 10+ years of participating the markets, most of my winning trades have come from shorting. I have a bias to wanting to short, as mentioned by the Doc, the momentum on a short time frame like 2008 makes trading feel a lot easier; going long requires more patience on my part to hang on to winning position.

I will forever be student of the market.

Love the TradeFeed blog!