Friday, February 28, 2020

Two Important Lessons From This Market Decline

Above we can see the ES futures covering the SPX 500 stock index as of my writing this at 4:28 AM on Friday morning.  It's been a busy week in the market, and it's been busy work with traders.  With a VIX suddenly three times as large as we had been seeing earlier this week, market volume and market volatility are much greater than anything we've seen in a long time.  Here are two important lessons passed along from my recent meetings with traders and portfolio managers:

1)  Risk management becomes crucial in volatile markets - Many traders see opportunity and want to size up, forgetting that volatility is already sizing up the movement of their positions.  The relationship between volume and realized price movement is not a linear one.  Not only do we see more volume in down markets like the current one, but the movement per unit of volume increases significantly.  If holding period stays the same, we are taking on considerably more movement in these down markets.  Many traders have been hurt by failing to take this into account.  They set stops too tight and the movement stops them out prematurely.  They size too large and then take losses much greater than they are accustomed.  It is easy to overtrade volatile markets, because so many things are moving.  That makes it easier to take a series of outsized losses.  The faster the market moves, the slower we should make ourselves to adapt to the new conditions.

2)  Not all oversold markets are ready to sustain a bounce - We were very oversold early in the day yesterday and many traders rightly entertained the notion that we could sustain an upside move.  Indeed, if you look at the chart above, you can see that we had good buying after the opening down move yesterday.  Note the green bars, showing that a high proportion of the volume traded was lifting offers, showing buying aggressiveness.  Also note, however, that all this buying only retraced a modest percentage of the prior market decline.  As impressive as the buying was at the time, in the context of the market movement, it was merely a bounce in a declining market.  Historically, yes, oversold markets do tend to rally.  When we're faced with a unique situation such as a virus outbreak, however, history is not necessarily an accurate guide to the future.

Volatile, declining markets can offer great opportunity, but also can play havoc with our psychology if we're bringing habit patterns from the prior period of low volatility bullishness.  With an uncertain U.S. election and an uncertain course of this virus, we could be seeing volatility in markets for a while.

Further Reading: