Tuesday, March 06, 2018

Volatility issues

Below I have shown a chart of the Dow which highlights the split personality of the markets in recent times.

Up until the end of January, we can see the market clearly in a trending, stable (i.e. low volatility) state. From there, the chart is a mess, and the Volatility Factor and 2ATR measurements clearly show the explosion in volatility.

Normally volatility is great for shorter-term traders, who can capitalise on the intra-day movements, which could be worth several hundred points. 

However, I've had some interesting conversations over the last week or two with traders who have failed to account for this increase in volatility, and have suffered as a result. 

One such trader has managed to incur a significant drawdown trading the indices on an intra-day basis. He thought he was being very disciplined by risking a minimal amount of his equity on each trade - and he was. However, the problem was that he did not make the necessary adjustments to reflect the increased volatility in the markets he traded.

While keeping his risk per trade small (which was good), he failed to reduce his position size and increase his initial stop distance. This meant that, with the jump in volatility, he was a sitting duck in terms of being chewed up and spat out by the markets.

While he was often getting into the market at the right time, the whipsawing meant he was continually getting stopped out before the position had a chance to move in his favour.

Subconsciously, this was because he felt that reducing his position size would almost make trading not worth his while. So, as he didn't increase his risk per trade, nor his position size, he was unable to adjust his initial stop distance.

It is for good reason that lots of successful traders adopt volatility-based position sizing and initial stop placement. Using a multiple of average true range is as good a method as any.

This volatility caused a further issue too.

On the trades which did move in his favour, he was 'frightened' out of those positions before he got an exit signal. In essence, he took profits far too early for fear of the volatility taking them away.

He ended up frustrated when he could see that there were 300-500 point intra-day swings in the Dow, and he got into a trade at the start of some of those moves, but he actually ended up losing money! 

This came from a combination of fear of losing minimal profits, and then trying to jump back in again further on in the price move, only to be whipsawed out of those additional trades.

Unsurprisingly, this frustration lead to pent-up anger and an erosion of trading capital.

Finally, to top things off, the anger manifested itself with a bout of 'revenge' trading, where he would increase his position size in an attempt to recoup those losses, but he STILL did not adjust his position size and initial stop distance accordingly. 

You can guess how that turned out...

I suspect this is not an isolated case. In recent months, I have mentioned a few times in tweets or blog posts concern over how traders relatively new to the markets will have only seen and experienced low-volatility conditions. This is apparent on all timeframes, so is relevant to day traders through to trend followers.

Remember also that, while volatility has been significant, the general intra-day moves recently seen are still smaller in percentage terms than those experienced in 2008.

Unfortunately, the market has a knack of sniffing out your weak spots, either in your mindset, risk control or method.

This is just one example where a failure to adjust position sizing and initial stop placement caused a lot of small losses (a form of 'death by a thousand cuts'), plus mindset issues where profits were taken far too early on other trades, and finally a series of irrational revenge trades where risk control was abandoned. 

All in all, he has paid an expensive tuition fee.

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