Monday, April 13, 2009

Diagnose Before You Intervene: The Challenge of Slow Markets


Here is a chart that illuminates a topic of discussion that I've had with several prop traders of late. They're finding that the market has become "slow" and it's more difficult to make money than it had been earlier in the year and especially in 2008.

Learning to trade in the recent markets is a mixed blessing. There have been good opportunities--price movement has been abundant--but the downside is that new traders implicitly expect high volatility to be the norm. Once a VIX of 50 seems normal, moving below 40 feels slow, even though that is still good volatility from a historical perspective.

The chart shows five-day average high-low range in SPY (a measure of daytrading opportunity) versus SPY itself for 2009. Notice how, in the last five days, we've seen about half the average range (and thus half the average intraday movement) that we saw early in March and late in January.

That is nowhere near the sub 1% ranges we used to see when VIX was in the teens, but someone learning markets in a super volatile environment can't appreciate that.

It goes back to the issue of volume, participation, and the changing rules of the trading game. Developing traders are playing blackjack as if there are a fixed number of decks in the shoe; they assume that, if picture cards haven't been showing up for a while, we're due for a run. Meanwhile, Mr. Market, the casino dealer, is changing the number of decks periodically, foiling the card counting.

Once volatility changes significantly, old assumptions about where stops should be placed (how much the market is likely to go against you) and where targets should be set (how much the market is likely to give you) go out the window. Much trader drawdown and frustration starts with a failure to adapt to this reality.

But, if you're really sharp, you'll realize that volatility changes due to volume shifts also reflect a difference in *who* is in the market. Markets move differently based upon who is participating; setups that work in one set of market conditions don't necessarily work in others. Many, many active traders I meet don't get that and spend a great deal of time spinning their wheels with erratic results.

Markets dominated by directionally oriented fund traders move differently than markets dominated by market makers and market making algorithms. A good physician diagnoses a patient before selecting an intervention: a medication or a surgical procedure. Developing traders would do well to follow that example: first "diagnose" market conditions, then figure out what is most likely to work in that environment.
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