Monday, May 26, 2014

Volume and Volatility: Why Many Traders Have Not Been Making Money Lately

Here's an update of a 2009 post, showing how daily volatility in the S&P 500 Index varies as a function of daily volume.  Specifically, we're looking at daily true range in percentile terms as a function of hundreds of millions of shares in SPY.  What we can see is that, as volume comes out of a market, movement also becomes less.  Since 2012, we've had 155 days in which daily volume in SPY has been under 100 million shares.  The market has moved over 1% on a true range basis on only 11 of those days--about 7% of the time.  When volume has been between 100 and 150 million shares, we've had 1+% days on 104 out of 283 occasions--over one third of the time.  When volume has exceeded 150 million shares, 140 out of 162 occasions--over 86%--move by more than 1%.

With VIX below 12 and recent volume at the bottom of the above range, we're seeing little average daily movement in stocks.  Only 5 out of 17 days in May so far have displayed a true range exceeding 1%.  What commonly happens to traders in such an environment is that they will attempt to construct trades with superior reward-to-risk ratios and implicitly set their profit targets too high.  If their entry execution is good, the market will initially move their way, only to stall out and reverse before hitting the intended target.  Hence the frustration many traders feel in a low vol environment:  trades that used to go their way for a profit now fizzle out and have to be stopped for no gain or a small loss.

It feels to a trader as if his or her style is no longer working.  But that isn't precisely correct:  the trading style may be working fine, but yielding less.  The problem is not with the trading method, but with the trading expectations.  The market continues to move some fraction of a true range each time unit; it's just that the range is shrinking in a lower volume environment.  The lower the volume and volatility, the more the trading becomes opportunistic:  make it, take it.  Markets won't move much, so when they move your way, you have to be thinking about taking profits.  The wrong strategy is scaling into trades once there is price confirmation; by the time there is price confirmation, the market is ready to reverse (just as you're sized largest).

This is why I find real-time monitoring of volume to be essential when trading the day timeframe.  How much participation is coming into or out of the market will determine how far a market will move for or against me.  Setting stops and price targets at the inception of the trade is important.  Equally important is monitoring volume and volatility during the trade and adjusting those price levels accordingly.  

Automobile traffic shows the reverse pattern:  as the volume of traffic increases on a given road, average speeds will decrease.  Traffic can move 65 miles per hour on an open highway, but might crawl at 15 mph during rush hour.  Drivers learn to adjust their speed to fit the volume of traffic.  It's a good lesson for traders as well.

Further Reading:  Is There Opportunity in the Market?