Thursday, February 26, 2015

Volume and Volatility: What They Mean for Our Trading

There is a close relationship between the volume traded in the stock market on a given day and the volatility of price movement during that day.  Since the start of 2014, for example, the volume in the SPY ETF has correlated .87 with the true range for that day.  When we trade more volume, it means that there is more speculative, directional participation in the market--and that tends to move prices.  Savvy day traders realize that and will gravitate to stocks trading on elevated volume for the day, as these provide the greatest profit potential.

The relationship between volume and volatility, however, is not a simple, linear one--and this creates challenges for traders.  Here 's a simple example:  During the last three trading days, SPY has averaged volume of roughly 72 million shares.  The average true range during that period has been less than half a percent or roughly 1 SPY point.  At the end of January, volume over a three day period averaged over 170 million shares.  The average true range during that period was about 1.8 percent or over 3 SPY points.  Volatility picked up by more than you would have expected as a linear function of volume.

The chart above of "pure volatility" represents the amount of volatility we obtain from a given unit of volume in the ES futures.  Note that, at present, the same amount of volume is giving us one quarter of the movement as it did when we made a low in mid January.  Not only do we see volume changing over time; as market cycles mature, the amount of movement provided by volatility changes.  

The bottom line for the current market is that we are seeing less volume *and* each unit of volume is giving us less movement than earlier this year.  That drying up of movement means that we can expect significantly less follow through on market moves than we might normally expect.  That has huge implications for trade management:  the sizing of positions, placement of stops, and establishment of price targets.  It also has meaningful implications for trading psychology, as the lack of movement makes it easy to overtrade the market in the effort to get something going.  

What that means in practice is that it's important to anticipate the amount of participation and movement in the market during your trade and factor that into your planning.  Less volume means that the proportion of directional participants to market makers is reduced.  That makes for a different kind of movement, with reduced momentum/increased choppiness in the short term.  One of the most common trading mistakes I see is that traders do not make proper trading or psychological adjustments to shifts in volatility regimes.

Further Reading:  Why Trading is So Difficult