Wednesday, March 31, 2010

Defining Effective Price Targets With the Previous Day's Data

In my recent post, I emphasized that every trade idea that includes risk and reward necessarily makes assumptions about both market direction and volatility. Traders encounter problems when they are right about market direction, but either underestimate volatility (and leave potential profits on the table) or overestimate it (and see winning trades reverse on them and often become losers).

So how does one define effective price targets that have a reasonable, known probability of getting hit?

The market itself provides us with some valuable targets.

Going back to late 2002 in the S&P 500 Index (SPY), for example, we find that only about 12% of all days are inside days. The odds are quite good that today's market will take out yesterday's high or low price. If we open somewhere within yesterday's trading range, we can then use our readings of evolving market direction (sector behavior, intermarket relationships, sentiment) to handicap the odds of hitting one of those price levels before touching the other one.

The advantage of using yesterday's data to frame today's targets is that we're allowing the most recent estimate of volatility guide our expectations about today's volatility. We can then update today's relative volume as the market is trading to modify those expectations as needed.

For instance, if we define yesterday's average price simply as the average of yesterday's high and low, we find out that, since late 2002, we've traded today at yesterday's average price about 60% of the time. That is useful information for those occasions where we open above or below yesterday's average price, but cannot sustain buying or selling. We can then target a reversion to the average price of the previous day, because we cannot sustain value higher.

Interestingly, the statistics are similar for weekly data, so that we can expect this week's trade to take out either last week's high or low and can expect a high proportion of occasions in which the current week's trade will touch last week's average price. This can be helpful in framing targets for swing trades.

The odds of exceeding highs or lows are even higher when we frame overnight highs and lows as initial targets for futures contracts. Well over 90% of days take out either their overnight high or low, so when we open within the overnight range, a worthwhile initial trade is to play for one of those levels once we see evidence of a directional bias to the day's trade.

The beauty is that, in using these levels, we automatically adjust assumptions regarding volatility based on how the market has traded most recently.

In my next post we'll see how we might build upon that.