Saturday, August 01, 2015

Getting Past the Frustration of Trading Choppy Markets

When we have difficulty arriving at solutions, many times it's because we haven't spent sufficient time defining the relevant problem.

Trading major U.S. stock indexes the past several months has been quite interesting, as we've traded within a range throughout that time.  Several sectors--most notably commodity-related shares--have been unusually weak; several sectors (consumer discretionary, healthcare) have been relatively strong.  Altogether the major indexes have gone nowhere, though they've traveled a considerable distance within their range.  That's the very definition of a low-Sharpe asset.

It's not unusual to hear traders lament such "choppy" markets.  What they're really saying is that the market isn't sustaining directional movement over intended holding periods.  The trader wants to profit from a move from X to Y in Z time period, but the market will move from X to X' and reverse to X or beyond before it ever gets to Y in the Z period.  For the trader hoping to plan a trade with good risk/reward--a price target twice as far away as their stop-out level (or more)--such choppiness leads to frustration.  An intended 2:1 reward-to-risk trade isn't so favorable when you're stopped out three times as often as you hit the target! 

Hence the lament:  choppy markets just aren't tradeable.

Been there, done that:  this week alone I had several intraday trades in ES that moved 4-5 points in my favor before retracing and moving against me.  Frustrating.

That led me to spend more time defining the problem.  

Suppose we model any market time series as the sum of a linear (trend) component and one or more cyclical components.  (John Ehlers' work is a good example of this kind of thinking).  To the extent that there is little cyclical component and a dominant linear component, we have a consistently trending market where buy/sell and hold would be an ideal strategy.  To the extent that there is little linear component and a dominant cyclical component, we have a consistently oscillating, mean-reverting market, where fading overbought and oversold levels would be an ideal strategy.

Of course, the financial world is a bit more complex than that, as linear components can vary in their slope and cyclical components can vary in both frequency and amplitude.  The relative balance between linear and cyclical components changes over time, as do slope, frequency, and amplitude.  This means that any single approach to trading markets--trend following, counter-trend trading--will go through winning and losing periods simply as a function of changing cycles.

So let us define choppy markets as ones with low linear component and cyclical components with high frequency and low amplitude.  That would define a low VIX market (low amplitude) with minimal persistence of directional movement.

Such a market is untradeable only if you need to trade directional trends of a certain size and duration.  Consider:  within each cycle, there are linear/directional components; these simply last for less time and travel less distance when the cycles are higher in frequency and lower in amplitude.  If you were to model those cycles, however, you would find that, for any stable market period, directional moves of X can be expected for holding periods of half the dominant cycle frequency.

Traders frustrated by choppy markets might turn to psychoanalysis, but cycle analysis is probably more relevant and helpful.  I modeled the recent market linear and cyclical components after my frustrating trades (hint: cycles are clearer when you don't use time as your X-axis) and, sure enough, I found that the odds of hitting my price targets given the current regime were actually quite low.  A move of 4 ES points was expectable in my intended holding period; a move of 8 points was unlikely.

A common piece of market wisdom is that traders must trade in a way that is consistent with their personalities.  There is truth to that--a quantitative investor probably will not do well as a discretionary day trader--but all too often that principle is used to justify sticking with trading methods that simply do not fit market conditions.  No one would tell an owner of commercial radio stations to program the airwaves to fit his or her personality.  Rather, programming would need to fit the marketplace of targeted listeners.  Similarly, traders need to adapt to *their* marketplace--and then re-adapt as that marketplace evolves.

Perhaps the problem is not choppy markets, but static traders.  When all we have is a hammer, Maslow noted, we inevitably treat everything as nails.

Further Reading:  Understanding Market Cycles