Current market volatility and staying the course

In the last couple of weeks we have seen an ever-increasing level of volatility within the context of a sharp drop in price in the major market averages.

We have also started to see intervention in the markets by governments and regulators - additional liquidity being provided and interest rate cuts, as well as market trading halts (up and down) being triggered and the introduction of short selling bans on certain stocks.

You think the markets are volatile? Think again...

I've mentioned a few times this year, both here and on social media, that the current levels of volatility may seem quite high (certainly compared to the more 'normal' recent levels), but these are nowhere near the levels seen in 2008.

To show what I am talking about, at the bottom of this post I've shown the monthly chart of the Dow going back to the early 1970's. And then, I created a simple measurement to show the change in volatility, by taking the typical 2ATR measurement calculation and expressing this as a percentage of current price.

Trading the line of least resistance

A lot of the people who were profitable in 2008 became unstuck the following year. They seemed to get in their head that, once the markets started rallying, they were anticipating a further, more pronounced price drop.

In the summer of 2009, they got their chance. There were numerous trading blogs of the day talking about a 'head and shoulders' pattern which had formed on the indices between May and June, and they were going to use this as a trigger to go short the market, and really make a killing.

Ten years on - the critical lessons I learnt from 2008

Ten years ago the equity and financial markets were in the middle of an unprecedented period. My interactions with the markets around that time were the ultimate proving ground for putting into practice what I had learnt and developed over the previous few years, and my experiences over those few months helped propel me forward as a trend follower.

Some of it wasn't easy, and some lessons learnt (and re-learnt!) cost me money. But in the long run, the tuition fees paid have been covered many times over.

Here are some of the lessons I learned from that time, which still form part of my overall approach:

Bitcoin and the evaporation of open profits

One of the most difficult aspects of trend following for inexperienced traders to accept is that you never get out at the extreme of a price move, and that there is always an element of 'giving back' a portion of open profits before an exit signal is given.

Generally speaking, the longer-term the trends you are trying to capture, the more wiggle-room your trailing stops need to give to current price action - this is to ensure that you are not stopped out due to a relatively minor retracement or price noise.

When starting to trade a new method or parameters, even if you have may be got the confidence of decent back testing results, there is still the big step into the unknown when it comes to dealing with the psychological element of letting profits evaporate when you have real money in the game.

This was brought home to me recently when discussing a long-term trend following system with an aspiring trend follower.

Jesse Livermore, the Dow and the changing market state

Below we have the current daily chart of the Dow. This is a classic example of a 'tale of two market states'. Up to the beginning of February, we can see a stable (low volatility), trending state. And from the beginning of February to date, a volatile, non-trending state. This is highlighted by the rise in the readings of the volatility factor indicator and the 2ATR measurement.

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.

A tale of two setups

Rather than talk about the recent market shenanigans, the chart of the Dow covering the last few months offer us a good chance to compare a low volatility setup against a higher volatility setup.

The rules of the game haven't changed

I started getting involved in trading back in 2003, and didn't get into trend following until 2006. As a result, I missed the huge trends (both up and down) from the dot.com bubble around the millennium.

While thinking idly back to those times, which are now getting on for 20 years ago (yikes!), I began pondering about how things have changed in the intervening period.

Back then, Facebook and Twitter didn't exist. The dot.com bubble sprang from something new to the masses called the internet. Mobile phones were nowhere near as common as they are today.

How on earth did we survive?

And that got me thinking, from a trading and historical viewpoint.

Some thoughts on volatility

Below is a chart of the Dow where I have zoomed out to show a longer-term view going back more than a decade. This shows that the current levels of volatility (as expressed by the 2ATR measurement) have only been reached three times in the last 8 years:

• August 2015 - when there was a short, sharp movement downwards which got quickly repelled;
• August 2011 - ditto
• 2008 through to early 2009 - when we were in the throes of the financial crisis and the big market downtrend.

A broader perspective on 2015

So that's another year come and gone - and one of the weirdest from a trading perspective. I've seen one or two people refer to 2015 as 'The Year of the Failed Breakout', and I certainly wouldn't disagree with that!

I can remember that moving from 2010 to 2011 seemingly changed the state of the markets from a trending to a non-trending state - certainly on my preferred timeframe. It was literally like someone had flicked a switched on 01 January.

These kind of changes can occur at any time, and when they do, we never know how long the new market state will last for. And, in the case of the markets switching from a non-trending to a trending state, we do not know what the magnitude of the new trend will be - or initially even the direction it will take.

An example of a failed setup

I recently posted a potential long setup which appeared on the Dow (see here for more). With last week's price action, this setup has now been invalidated.

As we can see, price has started moving in the opposite direction to that I was looking to trade, coupled with a sharp jump in the 2ATR volatility measurement.

This type of setup failure has also occurred on a large number of long setups on individual stocks. While the setups originally identified may appeal and meet all my criteria, a lot of them never trigger an entry.

What's there not to like?

It is not often that I post up a potential set up before it decides whether to trigger an entry or not. It is even rarer for me to trade one of the major indices. However, I was struck by the current set up on the chart of the Dow (see below). The S&P and Nasdaq are also showing similar characteristics and price structure.

That was the week that was

Last week will have been an educational experience for many people, particularly those who have started trading since 2008.

Since the major market averages bottomed out in early 2009, they have generally been in a steady uptrend. There have been one or two short periods where there has been some downside volatility (August 2011 and early October 2014 spring to mind) but they were small beer to what happened over the last few sessions.

Then again, we still need to put this into perspective, particularly with people calling the beginning of the week a crash or even 'Black Monday'. Last Monday, the FTSE and DAX fell more than 5%, and the Dow fell just over 3.5%, although intra-day it fell a lot more. Back in 2008, the Dow fell more than 7% on more than one occasion.  And further back in 1987, the Dow fell more than 22% in on the real 'Black Monday' - now that's a crash!

2015 - any parallels to 1987?

As a trend follower, I'm not in the business of making predictions - I follow where price goes. Elaine Garzarelli I am not. Also, predictions can easily blow up in your face if you are proven wrong. On this post, however, I am simply observing and pointing out a few comparisons between what is happening now and what occurred twenty eight years ago.

So what happened in 1987? 

• The crash followed a recent move down from all-time highs made a couple of months earlier;
• There was an international situation which contributed to the price move - in this case, it was the spat between James Baker and the Germans;
• Price accelerated to the downside throughout the week, culminating in a big drop on the Friday on heavy volume.

A wild week

This week has certainly been a wild ride - predominantly to the downside. There was a quick 300 point rally in the DAX this morning but that was quickly eroded, with price now back to the overnight lows.

This is a microcosm of what market downtrends tend to be like - sharp relief rallies followed a further lung to the downside.

Price and volatility contraction - the coiling of a spring

According to an article on CNBC this week, the Dow is on course to form its tightest price range (in percentage terms) in the first half of any year since its inception back in 1896.

Price has currently remained within a range of just over 6% so far within 2015. Sure, there have been some sharp moves on a intra-day basis, or over the course of a day or two, but these have all been contained within those basic price boundaries.

An argument against market direction determining your bias

I've been pondering further the question of letting the general market direction determine your trading bias, against focusing solely on the price action of stocks that you are looking to trade.

Regular readers of the blog will know that I made the decision late last year to place less reliance on what the major market averages were doing, as I was not looking to trade them. I look to trade individual stocks based on what their own price action is telling me.

Profiting from market downtrends

Trend followers and their performance tend to stand out from the rest of the trading community during a severe downtrend. There are reasons for this. Firstly, they simply follow the direction in the market.

Secondly, they avoid trying to pick a bottom in a stock or instrument. Finally, they also know when to exit a position and avoid losing the bulk of their profits.

Fiscal cliff and other market unknowns

The buzz words or phrase that everyone is referring to at the moment is 'Fiscal Cliff', and the possible impact it will have on the US economy, as well as the markets.

As it happens, the US indices have performed an abrupt about turn over the last few sessions of the year, and are now on short signals. Perhaps unsurprisingly, the major European indices are showing greater strength, but are also being dragged down in concert.