Wednesday, April 03, 2019

Why It's So Tough To Get Bigger In Your Trading

A common view is that our psychology is a prime determinant of our trading.  If we can master our psychology and follow our plans, we should be more consistent and we can trade larger.  Profits should flow.

I beg to differ.

What if the direction of causality is the reverse?  What if it's markets--and our trading of them--that impacts our psychology?  What if it's the markets themselves that make it difficult to get bigger in our trading?

One thing I've noted so far in 2019 is that many, many market participants are not doing as well as they might have predicted they'd do in a trending stock market environment.  That includes portfolio managers who invest in stocks, as well as traders who move in and out of stocks.

Why might that be?

I propose that the central challenge of recent markets has been the relative instability of market volatility. 

Here is a stark comparison:  During January, SPY averaged a daily volume of a little over 97 million shares.  During March, that average daily volume dropped to 80 million shares.  Daily volume ranged in January  from a high of 144 million shares to a low of 59 million shares.  Daily volume in March ranged from 122 million shares to 56 million shares.  Yesterday's volume was around 40 million shares.

Why is this important?

Since the start of the year, the correlation between daily volume in SPY and the daily true range of SPY has been .81.  In other words, well over 60% of all market volatility has been a function of volume traded.  Volume has been declining over time and this has helped account for a VIX that has moved from about 23 to 13 thus far this year.

But that's only part of the issue.

The standard deviation of daily true range in 2019 has been half as large as the average true range itself.  That creates a situation in which, during March alone, we can have days with ranges as much as 1.99%, 1.82%, 1.64%, and 1.52% and as little as .40%, .42%, .48%, and .49%.  In other words, volatility itself has been volatile.  Using recent history to gauge how much the market can move in the near term has been quite difficult.

But, wait, it gets worse.

I maintain my own measure of "pure volatility" which assesses the average amount of movement per unit of trading volume.  It tells us how much "juice" we can expect for every amount of volume traded.  So far in 2019, that pure volatility measure has been more than cut in half.  So not only are we getting less trading volume; we're getting less movement for each unit of volume traded.  This helps to explain why traders feel as if volatility has gotten "crushed".  It's a double-barrel effect:  less volume and also less movement for every unit of volume traded.

And it gets worse still!

During the past month alone, pure volatility has declined by well over 50%.  In the past month, we've had readings above 17 and readings around 10.  So not only is volume shifting quite a bit from day to day; the amount of movement created by that volume has been shifting.  That makes it very difficult to estimate how much a market can move going forward.

If we have instability of movement, it is extremely difficult to set rational stop out levels, price targets, place to add to or reduce positions, etc.  That makes it tough to manage positions and maintain favorable risk/reward--and it also makes it difficult to size up positions.  Just when traders think they have a stable environment and make some money, they size up their trades, only to have volume and volatility shift--and potentially work against them.  

Imagine a football quarterback playing a game on a field where the weather changes radically from quarter to quarter, minute to minute.  The running plays that worked well in the first quarter when conditions were dry now work poorly when the field is wet.  The passing plays that worked in warmer temperatures become harder when it's very cold.  Yes, the quarterback would get frustrated and lose confidence, but the fundamental problem is not one of psychology.  The quarterback needs a real time meteorologist, not a shrink.

Very few traders that I know have real time tools to help them gauge the volatility environment of the stocks, indexes, or markets they are trading.  As a result, they assume that patterns observed in the recent past will persist in the near-term future.  My analysis of volume, volatility, and pure volatility suggests that this is a faulty assumption.  The equivalent of the quarterback's real-time meteorologist would be real-time tools to assess who is in the market, what they're doing, and how that is impacting price movement.  From this regularly updated information, we could make more informed decisions about price targets, sizing, etc.  

It is not clear to me that staying calm, focused, and composed and sticking to pre-existing plans is a formula for success, either on changing football fields or in radically shifting markets.  In fast-changing circumstances, we need to develop the ability to think, plan, and execute on the fly--and we need the tools to help us make continuous adjustments.

Further Reading: