Saturday, May 07, 2016

Why The Path Is As Important As The Move

Let's think about the views that traders express.  Traders look for price movement: a change from one level to another level.  That potential movement we could call the numerator; it's what most traders focus upon.

There is another variable, the denominator, that most traders do not focus upon.  The denominator is the path between the first and second price levels.  It is equally important.

Let's do a thought experiment:  I might expect a stock index to move from 2000 to 2100, a 5% move.  Let's say the index remained nearly unchanged in value for six months before shooting higher to 2100 in the seventh month.  How many traders would have stuck with this trade?

Let's consider a different scenario:  The index moves from 2000 to 2100 in one month, but only after having dropped to 1940 in the first week.  How many traders would have stuck with this trade?

The point, of course, is that path matters.  When we expect a movement, we expect it in a certain time period and we expect the path to the target to have a certain degree of smoothness.  Our one concession to path is the establishment of stop levels, but rarely do we think of path as something to investigate in its own right.

Is the path getting smoother or more choppy?  Does the market's level of volatility support the likelihood of the desired move in a shorter or longer time period?  Is that volatility increasing or waning?

In short, it's easy to focus on what markets will do, but not place enough weight about how that movement is likely to occur.  Intellectually, we identify targets and stops, but what impacts us emotionally are paths.  It's easy to prepare for the trade and remain unprepared for the path of the trade.  

At any time frame, we can identify the amount of net movement between two points (how much price has risen or fallen) as a function of the total movement between two points.  Such a measure of trendiness versus choppiness itself waxes and wanes: trendiness is itself a phenomenon that trends.  Placing a trade in a low trending environment--and one where trending itself has been declining--is quite different from placing a trade in a high trending environment in which trending is itself trending. 

Thinking through the denominator is one way we can deploy capital smarter, deciding when environments are right for our ideas and when environments are more conducive to shorter-term, tactical trading and when they are conducive to longer-term, thematic views.

Further Reading:  Why So Many Traders Lose