Volatility Trading
The Smart Profits Report: Issue #353
Wednesday, September 13, 2006
Volatility Trading: Combat & Survive the Market’s Volatility Swings
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research
Lately, the equities markets have offered something for everyone. Everyone, that is, except trend followers.
Since the S&P 500 set a high of 1,326.70 on May 8 and then quickly dropped to a low of 1,219.29 on June 14, it’s traded in the range defined by those two intermediate-term extremes. In an otherwise relatively sideways market, that represents a pretty wild swing in volatility trading.
How a Sideways Market Produces a Volatility Swing
Back in June, I wrote about how the volatility had exploded - a 50% jump in a very short time, to levels not seen since the spring of 2003.
But today, the opposite has happened. Volatility has disappeared and we are at the lowest levels since late 2004. Here it is in chart form on the S&P 500 Index:
As you can see, day traders feasted on the high volatility for most of the summer. Now, they’re pining for the big moves of a month or two ago. (Whatever happened to the good ol’ days when day traders basically took the summer off and volatility took a holiday?)
Swing traders have experienced the worse of both worlds: High volatility stopped them out of trades on both the long and short side, and now the lack of volatility is keeping many swing-based systems on the sidelines.
So while the market has gone nowhere, when you go from multiyear volatility highs to multiyear volatility lows, it’s natural that the swings have driven most traders and their systems crazy.
Fortunately, however, there are some common-sense ways you can avoid getting caught in the same trap and navigate this volatility minefield…
How to Survive Volatility Trading Swings
No matter what kind of investment strategy you have, there are a few key approaches you can take to protect yourself from a big shift in volatility.
First of all, keep an eye on market volatility indicators every day. I like to use the Average True Range (ATR) indicator as a proxy for volatility trading. It’s the best tool I know for keeping track of volatility in the markets, or individual instruments.
Here are three more solutions:
- If You’re A Long-Term Trader: Be aware that volatility contractions typically lead to subsequent breakouts. Many top traders use various forms of volatility contraction signals as entry points for trades.
- If You’re A Swing Trader: Many swing trading systems are well-served by including a volatility screen to make sure that the markets are not too overheated or contracted before you trade.
- If You’re A Day Trader: Make sure you understand the current volatility environment, and don’t try to demand more from the market than it’s willing to give you. If the average range of the market you’re trading in is only eight points, don’t stay in trades waiting for 20-point moves!
Volatility swings can cause problems in the best of systems used within volatility trading. But with a little preparation and diligent observation, you can turn this monster into an ally.
Good Trading,
D.R. Barton, Jr.
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Today’s Smart Profits Cribsheet
- Learn how to be prepared for whatever the market throws at you by consulting the “VIX” on a regular basis. Mt. Vernon Research Chairman Karim Rahemtulla explains how this excellent volatility indicator works in Smart Profits #132, The VIX Index: Instant Access to the World’s ‘Best Contrarian Indicator.’
- Hefty market fluctuations can happen at any time - but it doesn’t mean you have to sit and watch as your portfolio turns red. Read Smart Profits #333, Options Strategies: The Perfect Options Strategies For A Seesaw Market.
Related Articles:
- Market Volatility: How to Pay $27 for a $50 Stock
- Position Sizing: The Most Powerful Investment Concept
- Exit Strategies: Prenuptial Agreements for Options
The Chart of the Week - Pat-On-The-Back Edition
