Tuesday, August 09, 2016

Why Volume is so Incredibly Important in Trading

We've all known traders who are permabears and permabulls.  Their dispositions lead them to favor one market direction over another.  Being a permabear or permabull is like reading all people as threatening or trustworthy.  Neither is conducive to social success.  We thrive in relationships when we learn to read others, not impose our dispositions onto them.  Traders are always in relationships with markets.  Traders thrive by reading markets, and that takes open-mindedness.

One of the most important things to read in any market is volume.  Per the recent important post, volume can tell us who is in the market; the combination of volume and price can tell us what they are doing and where they're doing it.  Markets are auction processes and to understand markets we need to see how much inventory is clearing and where the clearing is occurring.  It's not about shapes on charts or indicator readings or the next economic report or world event.  It's about who is participating in the auction and what they're doing.

This is why volume is so important.  A low volume market, such as we're currently seeing in U.S. stocks, is one in which market makers are dominant and longer time-frame participants are largely absent.  Why are they absent?  It's not just because it's August; take a look at how busy August, 2011 was.  It's because those longer timeframe participants do not perceive distinctive value right here, right now.  Sellers don't think prices are so high that they want to part with their inventory, and buyers don't think prices are so attractive that they want to scoop up inventory.  As a result, little volume occurs, and that means that we experience little price movement.

Since 2014, the correlation between the day's true price range in SPY and SPY volume for that day is +.87.  The great majority of volatility can be known simply by knowing volume.  That makes sense.  It's the larger, longer-timeframe, institutional participants who trade and invest directionally.  When they are in the market, we see more movement at every time frame.  Slow volume markets are quiet movement markets.  No one is there to push price meaningfully higher or lower.  That creates a very changed opportunity set for directional traders.

It also changes the nature of the opportunities.  Let's say I create a trading system that draws bands around current prices (as in Bollinger Bands) and enters long when we move above the upper band and enters short when we move below the lower band.  The target/exit is a defined distance above or below those bands.  In my research (and trading), that system makes money when volatility is above a threshold level and loses money when we fall below that level.  Same system, same signals, different results.

Why is this the case?  In higher volume and volatility markets, moves are more likely to extend.  In lower volume and volatility markets, moves are more likely to reverse.  What makes you money in one regime, loses it for you in another.  If you're not following the market auction process and identifying the regime we're in, you are less likely to adapt.  You're more likely to be dancing your same dance when the music has changed.

In low volume, low volatility markets, you have one of three good choices:  You can choose to not play; you can choose to play by a set of rules that works in slow auctions, or you can move to other instruments and markets that give you the volatility your trading needs to succeed.  The poor choice is doing the same f*cking thing that worked for you a few weeks ago in the name of "discipline" and "sticking to your process." 

Every time you begin trading, you're sitting down at a poker table.  How many people are around the table and who they are will matter greatly, helping to shape your betting strategy.  If you're at a car auction and want to sell your vehicle, how many people are bidding and how many of them are there to buy and sell will help shape whether and how you participate.  

And, oh yes, the correlation between volume today and volatility tomorrow is about +.57.  In the absence of a catalyst, when buyers and sellers accept value within a narrow range, that narrowness tends to persist.  Your disposition may lead you to look for breakouts, but a statistically significant number of times in slow markets, those breakouts are likely to be fake outs.

Further Reading:  Using Relative Volume in Your Trading