Friday, May 22, 2009

How Volatility Affects Future Price Movement Expectations

What a difference volatility makes!

Above we see two days in which the previous day's pivot price (an estimate of average trading price) was quite similar. We had a pivot price of 89.12 in SPY for yesterday and a price of 89.04 in the much more volatile environment of 11/14/08.

The proprietary R1/R2/R3 and S1/S2/S3 SPY profit targets that I calculate each morning before the open and post to Twitter are volatility adjusted and backtested to 2000. On about 70% of trading days, we will touch R1 or S1; roughly half the time we'll hit R2 or S2; and about a third of the time we will reach R3 or S3.

Above we see where the placement of those profit targets was for the two days. Notice how price movement expectations were so much higher in late 2008 than at present. It's a concrete illustration of how markets shift in volatility, not just direction, affecting where we place both stop loss points and profit targets. For another nice illustration, see this post on how VIX correlates with average daily volatility.