Saturday, April 25, 2020

Why Volatility Makes Such A Difference In Your Trading

Many traders have what Taleb would call fragile trading.  Their returns are vulnerable to changes in market volatility.  Interestingly, most traders focus on price and price direction.  They don't adapt their trading to market volatility, which impacts the momentum of price movement.

Let's take a close look at that.

Imagine a market with very great volatility, such as we had during the stretch between February and March this year.  Then imagine a market with very low volatility, such as we had at the start of 2018.  In that first week of 2018, VIX averaged between 9 and 10.  In the second week of March, 2020, the VIX average was in the mid 50s.  That tells us that options are anticipating more price movement going forward.  

During that first week of 2018, SPY volume averaged between 80 and 90 million shares.  SPY volume during the second week of March, 2020 averaged over 300 million shares traded.  The average daily true range in the first week of 2018 (actual, realized movement; not what options are pricing in) was around .70%.  The average daily true range in that first week of March, 2020 was about 4.50%.  Notice that volume expanded by 3 to 4 times between these periods, but actual movement expanded more than 6 times.  As markets become more and less volatile, each unit of volume gives us more or less movement.

For instance, we saw each unit of 50,000 contracts in the ES futures provide a range of a little more that 1 percent in that first week of March, 2020.  During the second week of November, 2019, when we averaged a VIX a little over 12, the average range for the 50,000 volume bars was under .15%!

Volatile markets tend to be busier markets, and each unit of busyness adds exponentially more price movement.  So when markets become less volatile, price movement *really* collapses, and when they become more volatile, price movement *really* expands.  Since the start of 2018, the correlation between daily SPY volume and daily average true range in SPY has been an incredible .87.  The important takeaway is:  Who is in the market determines how much the market moves.  This dynamic occurs at every time frame.

In busier markets, moves extend.  The trader can enter on strength or weakness and, on average, that strength or weakness will continue.  This is why momentum traders do so well in higher volatility environments.  In slower markets, those momo traders suffer.  They enter on strength or weakness and moves *don't* extend; they reverse.  The skilled trader in low volatility/low volume markets is getting long or short by fading selling and buying action that is drying up.  Quite simply, the trader could see the exact same price pattern or have the same idea in quiet vs. busier markets and would have to enter those trades differently and manage the positions differently.

(If you get the idea above, you can see why traditional patterns in technical analysis have such mixed results in objective backtests:  they play out differently in different markets.)  

Now you can see why traders often become frustrated and lose discipline when market conditions change.  Doing the same thing in different conditions brings different results.  If you're boxing against an aggressive opponent with poor defense you'll use different tactics than if you're fighting a counterpuncher who covers up well.  Good traders have playbooks for their best trades, as Mike Bellafiore has stressed.  What we see among great traders is different playbooks for different market conditions.  That is a big part of what makes them anti-fragile.

Further Reading: