Friday, November 02, 2007

Stock Market Volatility and Position Sizing

The VIX, a measure of options volatility, provides us with a good sense for the volatility of the stock market as a whole. I went back to 1998 (N = 2471 trading days) and examined the size of the next day's trading range in the S&P 500 Index (SPY) as a function of the current day's VIX reading. Here's what I found:

VIX greater or equal to 40 - median SPY range: 3.78% (N = 40)
VIX between 30 and 39.99 - median SPY range: 2.41% (N = 210)
VIX between 25 and 29.99 - median SPY range: 1.95% (N = 362)
VIX between 20 and 24.99 - median SPY range: 1.47% (N = 673)
VIX between 15 and 19.99 - median SPY range: 1.08% (N = 542)
VIX between 9 and 14.99 - median SPY range: .79% (N = 655)

What we can see is that the median range when the VIX is under 20 is about a third less than when it's between 20 and 25 and half that when it's over 25.

This has important implications for position sizing, particularly after days like Thursday when the VIX jumps significantly. If traders keep their position sizes standard, they could easily find themselves raising the volatility of their returns by 50% on a daily basis.

If the trader does not anticipate this rise in volatility, emotional reactivity to enhanced P/L swings is quite likely. It is also likely that any series of losing trades would create outsized losses for the trader.

In short, when the VIX jumps from 15 to 25, the effect is similar to doubling position size overnight. Moreover, markets will--to the eye of the trader--move twice as fast; a given market move will occur in half the time. This will make it feel as though markets are moving *differently*. Finally, when volatility doubles, the average movement against one's positions will double. If stop levels are not adjusted appropriately, it's easy to get stopped out and chopped up unless one's timing is impeccable.

Volatility is a great thing for a short-term trader; no one makes money if markets aren't moving. But markets that change their volatility rapidly offer their own pitfalls. The trader who becomes excited by volatility and trades more frequently with their standard size increases the volatility of his returns significantly. That has the potential to enhance emotional volatility.

And that is why I cut my size and adjust stops when markets become much more volatile. I risk a standard amount per bet, and I wait for my eye to adjust to the more rapid market movement. Making those changes proactively can save traders countless dollars and anguish.


VIX and Changing Market Cycles

The Psychology of Volatility