Friday, April 18, 2014

Determining Price Targets for Trades

I find that many traders are better at setting their entry points in markets than their exits.  In that sense, they are like archers who take great care to position the bow properly on their shoulders and pull the arrows with just the right amount of tension, only to lack proper targets.

There are many ways of defining price targets.  One might rely upon charts and define range extremes or price levels based upon wave relationships.  One might be fundamentally grounded and establish targets based upon a researched notion of fair value.  If every trade is to have a favorable relationship of reward to risk, it is important to have a target clearly in mind.  

My method of establishing targets in the stock market is statistical/mathematical.  Two things we can know from tests:  past volatility is positively and significantly correlated with future volatility and volume is positively and significantly correlated with volatility.  Volatility tells us how far we are likely to move in either direction over a given time period.  

So what I do is estimate today's volatility from recent volatility and identify the percentage probabilities of hitting particular upside and downside targets given that volatility level.  The key is estimating upside *and* downside targets.  These estimates have nothing to do with any directional view of markets I may hold.

Let's take an example.  If we were to open trade in SPY at 186.39 on Monday, my volatility model suggests a 78% likelihood that we would touch either the 187.13 level or the 185.65 level in that day's trade.  The odds of touching either 187.99 or 184.79 are a little under 25%.  So basically, think of a chart and next to each price level above and below where we're at, there's a probability estimate of hitting that level.

Again, this has nothing to do with my opinion about markets or my subjective reading of chart patterns, sentiment, the nation's politics, astrological formations, etc.  

Now, let's add an element to the estimation:

As the day's trade proceeds, we can identify if the current volume coming into the market equals, exceeds, or falls short of the volume that is typical for that time period.  So, for example, Thursday's first half-hour volume did not differ significantly from Wednesday's, but was lower than the average volume during preceding days.  Because volume and volatility are correlated, the updating of volume in real time allows me to adjust my estimates of reaching nearer and more distant price targets.  I identified quite early on Thursday (especially with it being the day before a holiday!) that we were unlikely to hit a distant, lower probability target.

This ability to adjust targets in real time is exceedingly useful, as participation during the day may greatly expand or contract based upon situational developments, such as an upcoming Fed announcement or a next day holiday.

There are many trading psychology lessons in all of this, and I'll address some of them in my next post.  From a trading perspective, let me simply mention that defining target probabilities is also very relevant to the setting of price stops and that this approach is scalable with respect to time.  Estimating the probability of hitting a particular target in the coming week or month draws upon the same process as estimating targets for the current trading day--and can provide a rational basis for holding vs. folding positions.

And, yes, this method can be used to estimate price targets for individual equities as well as indexes.  Indeed, it is relevant to any market in which volume and past volatility information provide a statistically valid basis for estimating future price movement.

My trading goal is to identify occasions in which my models provide a high probability directional view on the market and then to implement this view in a sound risk/reward structure with a) the calculation of price targets; b) the real-time (Bayesian) updating of the likelihood of reaching particular objectives; and c) continuously updated, real-time market indications of a directional bias to the day's trade by tracking the relative dominance of buying and selling pressure.

For those interested in the initial price targets, I will post a first approximation for SPY early in the trading day via StockTwits (@steenbab) as part of my market PREP posts.  Please note: my current method for determining targets is a refinement of my prior process, which is linked below.

CORRECTION TO THE POST:  Thanks to David Ayer for his helpful comment and correction to this post.  I identified the source of my error and the fifth paragraph above should read that, if we open at 186.39, we have a 72% probability of hitting either 187.38 or 185.40.  On the other hand, we have a 23% likelihood of touching either 188.37 or 184.41.  I am using something a bit different from 5-day ATR, so my numbers may differ from David's, but they should be in the same ball park.  I hereby amend the quote at the top of the post to read, "The odds of hitting your target go up dramatically when you calculate it properly."  :)

Further Reading:  My Previous Method for Calculating Targets