Monday, March 10, 2014

Adapting to Market Change When Trends Aren't Your Friends

Here is a chart of the average true range for the stock market on a rolling 100-day basis going back to 1997.  What you can see is that volatility has been all over the place.  Anyone in 2012 who counted on markets moving similarly to the prior several years has been severely disappointed.  Indeed, the current 100-day average true range is .88%, just a little over half the median level seen since 1997.  For directional traders, that means that moves on any time frame are extending far less than they have historically.  

So let's say that a trader waits for price confirmation (i.e., for prices to move in the desired direction) prior to entering a position.  Because moves extend less in a low-volatility environment, this means that going long on strength or going short on weakness (or adding to long positions on strength or adding to shorts on weakness) will give trades a particularly short half-life of profitability.  By the time the trader has gained confidence in the move, it's ready to reverse.  How frustrating is that?

Since 2009, we've gained a little over 100 points in SPY.  It's been quite a bull run, as the index has more than doubled.  If we separate next-day returns based upon prior five-day returns, then we can see that only a little more than 13 points of the total move followed the strongest half of five-day periods.  The remaining 88 points--nearly 90% of the total bull move--occurred following the weakest half of five-day periods.

In a low volatility regime, the short-term trend is not necessarily your friend.  It was great being a momentum trader in the late 1990s and many short-term traders I worked with did well during the volatility spike around 2008.  It's been harder for those traders from 2013 forward.  

How do you figure out what works in a more mean-reverting regime?  Studying your successful trades can provide a valuable clue.  It may be the case that you don't need to remake yourself.  Rather, the challenge might be to simply stop doing the things that no longer work.  Reverse engineering your best trades and isolating what makes them work can provide the best coaching of all.

Further Reading:  Stock Market Trends are Not Your Friends