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Stock Market Volatility

The Smart Profits Report: Issue #326
Wednesday, July 5, 2006

Stock Market Volatility: Three Ways to Combat Volatility’s “Radical” Shift
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research

When markets make a structural change, even if it is a relatively short-term change, trading and investing strategies are challenged, stressed and sometimes obliterated.

In the last two months, the U.S. equities markets have undergone a structural change that has little to do with the drop in prices.

The change has been in stock market volatility.

A Radical Change In Stock Market Volatility

Most people have concentrated on the price drop over the past two months. And while no one likes to have the stock market move against him, in absolute terms, we have had a relatively mild pullback so far. But in terms of volatility, we’ve had a radical change.

For perspective, let’s take a look at the recent drop on a weekly chart:

SINX Weekly [US] S&P 500 Index

The S&P 500 cash index hit a high of 1326.70 in early May and the low of the pullback was at 1219.29, for a drop of 8.1%. A significant drop, but not one that is even enough for market technicians to call it a correction! (And we’re currently only about 4.5% off of the highs.)

Volatility indicators tell another story. The stock market volatility, as measured by weekly range, has jumped 50% in the last few months. That is a real structural change that has taken us to the highest volatility levels of the last three years.

Turbulent Markets = Tough Times

How has your strategy or trading fared over the last two months?

If you’ve gotten whipsawed up and down or just outright taken a beating, you’re in good company. Some of the world’s best traders and money managers have suffered a similar fate in these choppy stock markets.

So what can you do when the markets are heading sideways or down while suffering violent swings in both directions? Here are some guidelines:

  • Reduce your position size. First and foremost, if your systems and strategies aren’t performing up to standard, cut back on position size until performance picks up. Yes, you may leave some profits on the table if we have a big move in your favor, but when the stock market is dishing up large quantities of uncertainty, the prudent action is to limit your exposure.
  • If your strategy is getting badly whipsawed, move to the sidelines. Many swing-trading systems are getting carved up like a Thanksgiving turkey right now. Many of the best intermediate-term systems have filters that allow them to sit on the sidelines in these turbulent markets. If yours doesn’t have this type of circuit breaker, then take some time out of the market until conditions are more ripe for profits.
  • Verify entry signals on longer-term systems. Because the stock markets are much more volatile than what we’ve experienced in the last three years, long-term systems may be generating poor quality entry signals. Make sure that your signal is taking into account today’s added volatility before you jump in.

The last thing traders can do is tighten their time frames. Profits that used to take days are now only taking hours. Intraday traders are enjoying the volatility. So until the turbulence subsides, consider a shorter time horizon or staying on the sidelines all together.

Good Trading,

D.R. Barton

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Today’s Smart Profits Cribsheet

  • My good friend Dr. Van Tharp has written the trading world’s definitive guide to trading and investing psychology and discipline. His Peak Performance Home Study Course is must reading for every serous trader and investor. Get your copy of this great study course now!
  • Another good friend of mine, Mt. Vernon Research Chairman Karim Rahemtulla, made the best of the volatility jump, playing volatility itself… While the market rocked portfolios across the board in June, subscribers to Karim’s LEAPS Trader made 48% on the Chicago Board Options Exchange Volatilty Index (^VIX). (They also made 68% on a Nasdaq 100 Trust bear spread.) To learn more about his elite trading service, please call our VIP Trading Services team at 888.570.9830.

Related Articles:

The Chart of the Week

AAPL Daily [Nasdaq] Apple Computer

Apple Computer (Nasdaq: AAPL) is not following the market’s lead - at least in terms of volatility. Apple’s volatility has been dropping significantly over the past months. Such volatility contractions usually precede large price moves. Watch the $55 area closely; a close below that area could trigger more downward movement. More likely is a bounce from this area to push higher. Be wary of bad news out of the French intellectual property battle that could trump any technical indications in the short run.

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