Saturday, October 14, 2017

The Great Mistake Traders Are Making

So here is a chart of two trending markets.  What are they?

The blue line is pretty familiar:  it's SPY since the start of 2016.  That's a pretty high Sharpe trend.

The red line is not so familiar:  it's a 100-day moving average of the average daily true range of SPY.  In other words, the red line represents average daily movement (realized volatility) of SPY.

Note that we're getting roughly one-third the movement each day that we saw early in 2016.  And it's not getting better:  the past five trading sessions have averaged a daily true range of .33%.  That is closer to one-fifth the movement we saw early in 2016.

No wonder active traders have been challenged lately.  It's difficult being a directional trader when there is little movement in the instruments you're trading.

The one refrain I've heard from those active traders over the past two years is:  this is going to turn around.  Stocks are too expensive.  Rates are too low.  Volatility is too cheap.  Everyone wants to catch the turn and profit from the break.  So stocks dip, VIX bounces, put/call ratios go to the moon, and the trends continue.  Moderate growth with modest inflation and low interest rates that make stocks a desirable carry instrument mean that SPY has ground higher and vol has ground lower.

Traders' forecasts for reversals in stocks and vol have had more of a psychological grounding than a logical one.  Hope is not a business plan and it's not an edge in markets.  What has been more successful have been strategies that have targeted small cap and higher volume momo stocks that provide greater average daily movement.  Also successful has been migration to asset classes providing greater volatility, from commodities to cryptocurrencies.  And what has been successful has been true trend-following:  investing (not actively trading) equity and vol products.

The point here is that markets go through regimes and those regimes can last longer than traditionalists can stay solvent.  The momo boom of the late 1990s killed short-sellers accustomed to price action from the 1980s.  The collapse of momentum and bear markets of 2000 and 2008 wiped out many who had benefited from the prior bull market.  Now we're seeing a regime in which there is a major bear market in volatility, quite the change from 2007-2009.

This too shall change.  As I've noted earlier, volatility bottomed in late 1993 and late 1995, only to see the bull market really roar on higher volatility into 2000.  It's not inconceivable those dynamics could repeat themselves, with debt and low interest rates and fiscal stimulus stoking an already growing economy with low official unemployment.  A rise in vol does not necessarily entail a bear market in stocks.

But that is tomorrow.  Our job as active traders is to profit today.  We trade what we see, not what we crystal ball.  Adapting to the current regime requires a rethink about what we trade and how we trade it.  There *is* opportunity out there.  One active trader I work with had career high P/L this past week--just as VIX was languishing in single digits.  It can be done.  But not by merely hoping.

Further Reading:  The Market Is NOT Broken