Monday, August 31, 2009

Volatility-Adjusted Price Targets for Swing Trading

As background for this post, I recommend that you review the posts on swing trading with weekly price targets and swing trading with weekly pivot levels.

I recently wrote on the topic of how daytrading was offering limited opportunity sets, particularly for those who have been trading the stock market indexes. The reason for this is that an increasing proportion of total index movement has been initiated overseas. Those who close their positions out by the end of the day find themselves missing nice market moves that they might have seen coming.

Indeed, many of the daytraders who I work with and hear from who are doing well this year are not trading the indexes. Instead, they have found creative ways of finding stocks and sectors that offer excellent intraday movement, trends, and reversals.

Readers are aware that, each morning before the market open, I publish proprietary daily price targets for the S&P 500 Index (SPY). These are volatility adjusted, so that expectations of movement reflect the recent volatility of the market. Each day there is a pivot level, which is an approximation of the day's average trading price and there are three upside targets (R1, R2, R3) and three downside targets (S1, S2, S3). Going back to the year 2000, we find that about 70% of all trading days touch their prior day's pivot; 70% will touch R1 or S1; 50% will hit R2 or S2; and 33% will reach R3 or S3. (Follow the Twitter stream here for profit target numbers and other indicators and alerts).

I have reconfigured weekly pivot levels with research going back to 2000 so that the numbers are analogous with the daily figures. The pivot level is an estimate of the average trading level of the prior week; R1/R2/R3 and S1/S2/S3 are the upside and downside targets. The odds of hitting the weekly targets are very similar to those for the daily targets.

Here are this week's weekly profit targets for SPY:

Pivot = 103.26
R1/R2/R3 = 105.89/106.42/107.12
S1/S2/S3 = 100.63/100.11/99.40

I use these weekly figures very similarly to the daily ones in framing targets for trades. For example, I mentioned on Friday that I had established a small short position in the S&P 500 Index after we rejected an effort to make new price highs amidst numerous divergences. With an entry of 103.19 on this swing trade, I'm looking for a move to at least 100.63, which would put us back into the early August trading range.

So what is my stop loss point? On Friday, I determined that I would stop out if we made new price highs. That put the stop at 104.35. Note that today's R1 level is 104.24. If we are indeed going to be heading lower, we should not be taking out R1 today. That means that the day's R1 level acts as a natural stop loss for the trade conceptualized on the swing time frame. That also means that my trade targeting (at minimum) the weekly S1 and stopping out at the daily R1 has a favorable risk/reward profile.

Thus far the trade has moved my way; note how I would have lost a nice piece of movement had I waited until the next day to execute my idea as a daytrade. To be sure, swing trades will carry a higher volatility of returns than trades executed on a day timeframe; the way to adjust for that volatility is simply to size swing trades smaller than day ones, so that too much of your portfolio is not exposed to the higher risk of the longer holding period. This is a far better strategy than placing stops too close to entry points.

With the daily and weekly levels, I find that I have a rational basis for placing stops and targets, and that helps me stick to those. Starting next week, I will be posting the weekly SPY price targets before the Monday open via Twitter.