Friday, March 06, 2009

The Low Volatility Decline Thus Far in 2009

A number of readers have written to me about the challenges of setting price targets. What is happening to many of them is that they are holding onto paper gains as positions go their way, only to see the market reverse prior to hitting their targets. What is going on?

The chart above helps to explain what might be happening. The market drop late in 2008 came on tremendous volatility. Notice how the 20-day moving average of the daily high-low range in the S&P 500 Index (SPY) rose significantly during that period. Note also that this was a time when we saw VIX levels soar above 80.

We have since moved to new bear market lows in SPY, but observe in the chart above how volatility has barely budged higher. We are approximately 50% lower in volatility than we were in October of 2008. The VIX has struggled to stay above 50 during the recent decline, whereas 50 was closer to a floor for the VIX during much of October and November, 2008.

So how does this affect day-to-day trading? Readers know that I calculate price targets for SPY based upon recent price action (the market pivot) and recent volatility. These targets are posted each morning via Twitter (free subscription via RSS). From 2004 through 2008, roughly 80% of all market days touched either their R1 or S1 target levels during the day session in SPY. During 2009, however, that percentage has dwindled to 58%.

Interestingly, the percentage of days touching the prior day's pivot level (an approximation of the previous day's average price) has stayed constant during 2009 at around 70%. And we're seeing a relatively constant proportion of days taking out either their prior day's high or low price. What we're not seeing is the accustomed extension of price movements.

That tells me that we might need to tighten price targets as long as volatility is not expanding in the way that it usually does during bear/trending moves. The prior day's high/low is generally a good initial target for days in which we open within the previous day's range. Traders should be aware that a larger number of days than usual have been stalling out before hitting the R1 or S1 targets. Keep an eye on Twitter later this morning; I'll post an intermediate set of targets that reflect these reduced expectations. (Last five Twitter "tweets" appear on the blog page under Twitter Trader or just subscribe).

The important thing to keep in mind is that this is not primarily a psychological issue; it's a matter of adapting to market conditions. It can cause psychological issues, however (see the link below), and that will be the topic of an upcoming blog post.