Wednesday, March 31, 2010

Every Trade Idea Includes Hidden Volatility Assumptions

This will begin a series of short posts on price targets, why they're helpful, and how I calculate them.

While many traders pay close attention to their entries, they don't always crystallize their ideas as to how far the market is likely to move in their direction. Without a clear idea of price targets, it's easy to exit positions too quickly or overstay your welcome and see moves in your favor reverse against you.

Price targets incorporate assumptions not only about directionality, but also volatility. This is where most traders get hung up: they focus on market direction, but their assumptions regarding volatility are hidden--and often inaccurate.

This is a very important concept: every trade idea embeds a hypothesis about *both* direction and volatility. When we calculate the risk and reward on a trade, we're making assumptions about how and how far the market could move in our direction. Bad calls on volatility could be as problematic over time as bad directional calls.

My goal, in part, is to make you more aware, more conscious of your volatility projections when you hold a trade toward a chosen objective or place a stop out point away from your expected direction.

So how can we adjust for volatility? There are two ways, and those will be topics for the next posts in this series.