For this blog post, I thought it appropriate to talk about the recent volatility we’ve had in the month of October. This month is usually a ‘spooky’ one for the markets. Black Monday occurred in October. This is the single biggest one day drop in the Dow, -22%. The Crash of 1929, which triggered the Great Depression, also happened in October. In 2008 the market fell as low as -25% within Oct 1st through Oct 27th.
Looking at the evidence, some of the worst short term drops in stock market history have happened in October. I’m not saying that this month will be the same as those previous Octobers, but volatility has returned in October of 2018. How does this affect trading in the markets? That will be the focus of this blog.
First, we need to define what volatility really means. Volatility is a measurement of the average range and volume for any given period of time. If the average range increases, then volatility has gone up. If the average range decreases, then volatility has gone down. Some where in between low volatility and high volatility is normal volatility. Another way to define volatility is uncertainty. If traders do not know what is going to happen in the next 3 months or the next 2 days, then there will more than likely be a mix of bulls and bears. A market that is two-sided, meaning having just as many buyers as sellers, always produces volatility. Think about it, over the past year, we have seen record low volatility and the market has only gone up. This is a one-sided market, buyers only. Introduce a bit of sellers and uncertainty, and you will get a two-sided market, a true showdown between bulls and bears.
To measure volatility in the stock market we use the CBOE Volatility Index (VIX). The VIX is an oscillating index between 0 and 100, where 0 is the lowest extreme and 100 is the highest extreme. A VIX reading of 10 to 17 is considered normal. A reading of 20 to 35 is considered fear in the market. And, a reading of 40 to 90 is just pure insanity and capitulation. Notice that I did not mention a reading of 0 or 100. Think of VIX in this way: According to Isaac Newton, every object in the universe is in motion. Later, Albert Einstein said that nothing can travel faster than the speed of light inside of a vacuum. Think of a 0 reading on the VIX as the only object that is not in motion, but absolutely still. Think of a 100 reading on the VIX as light and the speed of light. The closer we get to 0, the slower the markets become. The closer we get to 100, the faster the markets become.
Normal volatility is what we are all used to. Think of trading year 2017: The VIX had a normal reading all year long and a stock market that moved very slowly to the upside. Think of February of 2018 and October of 2018 and you will see how quickly the ranges in the market increased dramatically and how the VIX increased in value. Have a look at the following diagram displaying the VIX (Blue Line) in relation to the S&P 500 index (CandleSticks).
As you can see, when VIX goes up, markets tend to go down, but down in a very big way. After the markets go down, then they go back up, but up in a very big and fast way. Though there may seem to be a negative correlation between the S&P 500 and the VIX, the negative correlation is not always true. There are times where volatility goes up and so does the market. This is caused by the increase in range and volume created by a substantial move higher.
Increased range and volume are the side effects of high volatility markets. Most traders use a Buy/Sell system based on some technical indicators. The problem with Buy/Sell systems is that they are optimized for one kind of market environment and volatility reading. When Volatility increases those indicator settings will not provide the same risk vs reward. Statistically, it will increase your risk and decrease your reward.
Let’s use the S&P 500 Futures for example. Normal volatility normally keeps the S&P 500 inside of a 15pt range from high to low at a valuation of 2700pts. A reading of 20-35 in the VIX will increases that range to 30pts-50pts at the same valuation of 2700pts. That’s a big jump! With the heightened volatility, always keep in mind the Speed of Light Analogy. The higher the VIX the faster markets will move.
How do we reduce our risk and increase our reward?
Well, no matter the strategy that you are using, the first rule of trading high volatility is to decrease your contract size dramatically. If you are trading 5 contracts in the S&P 500 futures, then maybe you should consider trading 1 to 2 contracts during high volatility periods. That is how to reduce risk.
To increase our reward, you will need to increase the number of contracts in your positions. I know I sound contradicting to my previous statement but hear me out. During normal volatility periods, we know that the range in the market will be reasonable enough to add to a losing position if you are looking to double down on a position. That is a death sentence during periods of heightened volatility. The only way to double down on a position is to add to a winning position. Consider this example: Assuming a VIX of 30 and a usual contract size of 5 contracts per trade reduced to 2 contracts in the S&P 500 futures to reduce risk. Now let’s say you get long at 2700 (2contracts). The market begins going your way and you are up about 10pts. This is the ideal situation to increase your risk because you now have a guaranteed cushion that will prevent you from losing money immediately after entering the trade if the trade doesn’t go your way. At this point, you add another 2 contracts, which puts you into a 4 contract trade which means more reward if the swing higher continues. In high volatility situations, we have seen 40pt-60pt swings in the S&P 500. Adding to winning positions will allow you to scale into your usual contract size and reap the benefits of a large market swing.
With the good also comes the bad. Let’s assume that you enter long the S&P 500 futures at 2700 with 2 contracts. You put a stop loss of 10pts and it gets hit. You lose -$1,000 on the trade. If you entered with the usual 5 contracts you just lost -$2500. In my opinion, its better to lose -$1k then -$2.5k. Lastly, let’s assume that you enter long at 2700 with 2 contracts. You add 2 more at 2710. Your average price is now 2705 meaning that you are up 5pts on your trade with 4 contracts. If you don’t want to risk any money, then place your stop loss at 2705 immediately after adding at 2710. If you chose to have the same risk as 2 contracts at 10pt stop, -$1k, then place your stop loss at 2700 immediately after adding at 2710.
How long do high volatility periods last?
To answer this question, let’s first look at a couple historical charts of VIX. This is not an Electrocardiogram (HaHa!).
15 Year – Weekly Chart of Volatility:
2017-2018 Daily Chart of Volatility:
After careful review of both charts, we can conclude that High Volatility periods don’t last for very long, but low volatility periods last longer. Over a 15-year period, the average amount of time spent above 20 has been approximately 120 days before volatility returns to a normalized value. Also, after a big spike above 40 (Capitulation), Volatility usually drops quickly, but markets don’t normalize as fast. The pattern is clear, spikes above 25 introduce a period of some 100+ days where ranges and volume increase. Now that we have traded above 25 on October 11th, its time to buckle up and enjoy the next 100+ days of range and volume. As day traders, this is the ideal situation for our day trading strategies and risk vs reward models.
The Current Stock Market Valuation & High Volatility
We are currently around All Time Highs in the market. This is the first time in stock market history that we have seen a 26,000 point Dow Jones, a 7400 Nasdaq, and a 2900 S&P 500. At these valuations the market seems very expensive. But that’s not the problem. The real problem is the valuations themselves. Under these high valuations, a high volatility environment can produce ranges that can seem excessive, but percentagewise are not too worrisome. For example, it was not normal to see a 1,000 point drop when the value was around 14,000pts back in 2013. But with a 26,000 Dow Jones, a simple 1,000 points is only about 4%.
With these higher valuations, the futures markets still have the same amount of leverage. Sometimes exchanges will deleverage a futures contract size because the market has a new higher valuation. Take the Russell 2000 futures for example. Not long ago was the tick size in this market $10, where as now it is only $5. Fortunately, this has not been the case for the other major indices. With valuations this high and leverage remaining the same, the opportunity to make a lot of money is there and it is during these high volatility environments where that money can be made very fast and with proper risk management, reduce your risk during these wild swinging markets.