Thursday, October 16, 2014

What Volatility Means for Your Trading Psychology

Ah, if it were only that easy!  I took a look at the average true range for the past five trading sessions in SPY.  It was almost 2.1%.  By contrast, at the July peak, the five day average true range was almost .53%.  So basically, in terms of realized price movement, we have quadrupled volatility in a span of about two months.

What does that mean for trader psychology?  Imagine quadrupling your trading size over the span of a couple of months.  How might that impact your trading?  By placing a magnifying glass on the dollar size of your P/L moves, it accentuates the potential psychological impact of wins and losses.  A random streak of four losing trades on quadruple size could wipe out a substantial portion of prior profitability.  Conversely, random large winning trades could convince a trader of his hot hand and lead to overconfidence and overtrading.

When volatility increases by several orders of magnitude, not only are the moves in the direction of the trend accentuated, but also the moves against the trend.  That means it's very easy to have a trade move 1% against you in minutes, where it would have taken a few days for such a move to materialize in the slower, low volatility market.  If your trading size is the same in a high volatility market as a low volatility one, you have effectively magnified your size by several times.  That does not mesh well with many people's risk tolerance.

The reason this is important is that spikes in volatility associated with intermediate-term market pullbacks are more common than recent experience would suggest.  Check out this very helpful blog post from Philosophical Economics.  Since World War II, we have seen 10% market corrections about 20% of the time and 15% corrections over 12% of the time.  This ensures that buy and hold investors will have meaningful drawdowns, and it also guarantees that career short-term traders will experience spikes in volatility.  Such spikes can represent meaningful opportunity, but only if one's emotional volatility is not tied to that of the market.

Further Reading:  Volume and Volatility