The Importance of Volatility and Range

Here’s a lesson that I’m consistently forced to re-learn: volatility and range matter.  A lot.  This is something which keeps coming up in my trading, and perhaps it represents a mental defect on my part that I can’t internalize it.  Hopefully you can do better.

My bread and butter trading is short term on the ES index future.  Each contract represents $50 per point of the S&P index , so at current values each contract represents about $67,000 of S&P.  The contract “tick” is 1/4 of a point, or $12.50.  The method I use to enter my trades is something I really can’t share (sorry), but the exit structure of the trades is simple: a profit target limit order 7 ticks from the entry point, and a stop loss order 7 ticks in the opposite direction.  I never alter trades after entering them, so one of two things happens every trade: I make $87.50 per contract or lose $87.50 per contract.  Either way I pay $4.02 in commissions.

Over the past week, I’ve made 12 trades via this system – 8 winners and 4 losers.  Net profit is just slightly more than $300/contract.  This is quite good, although it’s actually slightly worse than I’ve been averaging.  It’s at the top end of the “small edges” chart, where very good things start to happen.  I’m pretty stoked about the success I’ve been having with it.  But there’s also a lesson in those four losses and I think I could do even better.  Three of the four occurred last Friday.  Now, there’s no question that this could be pure probabilistic coincidence.  If I win 2/3 of my trades, I’d expect to have 3 losing trades in a row every 27 trades.  It’s going to happen fairly frequently.  But in this case, I’m pretty sure (90%+) that it was no coincidence.  Take a look at Bloomberg’s economic calendar for last week and in particular what’s going on on Friday.  Specifically, nothing.  No economic reports.  Not even a T-bond auction.  Nothing.  Their “market focus” commentary was, and this is hilarious, “Quiet sessions have been rare this summer but would be welcome.”  In other words, despite being open, the market just decided to take Friday off more or less.

The result was fairly predictable: the S&P traded in a small range on Friday and pretty much nothing happened.  Now we get to my trading, in which I went 0-3 and suffered the worst draw down I’ve experienced in the last several weeks.  You’ll note that my trading method has built into in an expectation of volatility – the 7-tick profit target.  What I’m essentially saying is “If I’m right about market direction, the market will be peppy enough to move more than 7 ticks.”  Clearly this does not have to be the case.  It’s a system parameter that evolved over time as I experimented with the system.  I’m making an assumption that the future will look something like the past.

Friday’s market was less than peppy.  After entering each trade, the market almost immediately moved in my direction.  Not to brag, especially since I’m not sharing the system, but the predictive method I’m using really does appear to be very good.  But it the market didn’t move far enough – 5 ticks on the first trade, 6 on the second, and 7 ticks on the third (touching my limit profit target order), but I didn’t get a fill before the market moved back.  The 8 ticks of movement I needed for a guaranteed profit eluded me each time.  The market was moving when I expected it to, in the direction I expected it to, but not the amount I was expecting.  Gee, I  wonder if that could have anything to do with the general lack of volatility and range on Friday?

Of course it did.  Volume, volatility and range are the fuel for speculative trading.  If other people don’t want to do business, or only want to do business all that the same price, you can’t make any money.  It becomes possible to profit (or lose) when the market moves a meaningful amount.  Sleepy markets mostly benefit Manhattan lunch restaurants.  This is a place where speculative traders different from the typical investor (and the guy writing the Bloomberg “market focus” blurb).  Few investors would object to Friday’s market.  No one lost a big chunk of the 401K mutual fund portfolio’s value on Friday.  Of course they didn’t make much money either.

Now, you could argue that my Friday losses could be avoided or even reversed.  Knowing the market was going to move at half speed, I could have traded with a 4 tick profit target instead of 7 and gone 3-0 instead of 0-3.  These kinds of adjustments can be useful, but they can have problems too.  For example, do I move my stop loss to 4 ticks?  Overly close stops can be profit killers (I’ll explain why in another article).  Alternately I could have decided that if everyone else was going to take the day off, I should too.  Honestly, that was probably the smart move.  But it’s hard, when you’re trying to make money trading, to say “I’m not going to trade today”.  Maybe I’ll be smarter in the future.

The moral is this: if you have a trading system that is designed to operate at a specific volatility level and you expect the market to give you something different then your system needs to either be modified or temporarily abandoned.

 

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