Tuesday, December 16, 2014

An Important Reason Why Trading is so Difficult

Central to sound trading is taking trades that offer favorable reward relative to the risk taken.  This assumes, however, that we can accurately estimate both risk and reward--and the likelihood of achieving those.  That may sound easier than it proves to be in practice.

We know that volatility in the stock market is intimately connected with the volume of shares traded.  As the VIX has recently climbed from low double digits to over 20, volume in SPY has moved from less than 100 million shares per day in late November to close to 200 million shares in recent sessions.  Average daily true range has gone from about .50% in late November to over 1.5% in recent sessions.

Complicating the picture is that the relationship between volume and volatility itself changes over time.  The measure of pure volatility charted above shows the average amount of movement that we get for a given unit of market volume.  As markets peak, volume contracts, but a given unit of volume gives us less movement.  As markets fall, volume expands, and a given unit of volume gives us increasing volatility.  

The bottom line is that markets move much less near market tops and much more near market bottoms than we typically expect.  Both volume and the relationship of volume to volatility change frequently, so that traders who anchor expectations to the recent past are going to become poor estimators of movement going forward.  That will result in poor placement of stops and targets and poor decisions regarding when moves are likely to reverse vs. extend.

When traders leave too much on the table or overstay their welcome in trades, it's not necessarily emotions and poor discipline doing them in.  Rather, they are shooting at targets that are proving to be more fast moving than stationary.

Further Reading:  Pure Volatility and Market Efficiency