One of the major issues facing traders and investors in the current market climate is the extreme levels of volatility being experienced by all the world’s share market indexes. These extreme levels of volatility are also being experienced in almost all the world futures, currency, and commodity markets as traders and investors of all shapes and sizes struggle to come to grips with what is being termed the global financial crisis. This has resulted in huge intraday price swings across all markets as fear and panic grip market participants. Normally level headed and balanced traders are even prone to irrational behaviour under these conditions as they enter and exit trades on a whim or in reaction to news stories and other reports in the press. The day traders and short-term swing traders are both benefiting from and contributing to the volatility as they trade in and out of short-term moves and patterns.
The chart below provides a clear picture of what is happening in the Australian equity markets. Volatility as measured in percentage terms is approaching levels not seen since the 1987 crash. In 1987 volatility reached just over 12%, today it is around the 10% level. By comparison, during the 1997 correction, volatility was approximately 5.5%, and even the massive sell-off following the events of September 11, 2001 saw volatility levels of just over 4%.
A large number of traders are experiencing unprecedented levels of volatility, and really struggling to come to terms with what it all means for both their trading and investing activities. Many have only been involved in the markets through the relatively stable and low volatility period experienced during the bull market that began in 2003 and lasted until late 2007, and as a result, are confused and dazed by the current market volatility. Like a ‘deer in the headlights,’ they are stunned by this sudden intrusion, and totally bamboozled as to what to do next.
The good news is that the volatility will eventually ‘wash out’ and return to normal levels at some stage. The unknown, of course, is when. Following the 1987 crash, volatility took around 8 months to return to pre-crash levels. The fall in share prices then was however much sharper than the current crash. That crash happened over 2 days; this crash has so far taken several months to unfold.
The most important thing to do when trading during volatile times is to not only stick 100% to your trading rules but to also ensure that your trading plan has a method of reducing your exposure to the market. It’s this lightened exposure that will reduce drawdown in a portfolio and keep the investor ahead of the benchmark.
Mechanical investors have detailed trading plans that consist of market risk evaluation -either LOW or HIGH, money and risk management rules, and strict entry and exit signals for individual trades. It’s the rigor and rules that mechanical investors build out of the market that enable them to execute the plan IN the market.
It is also vitally important to know well beforehand what you will do when the volatility does return to normal, lower levels, which it will do. The prepared traders with a trading plan will know well in advance how and when they will re-engage the market and will act with certainty and confidence when the time comes. The unprepared will flop around nervous and uncertain as they wait for more and more ‘evidence’ to support their view, only to miss some great trades and add further to their own confusion.
Mechanical investors will know when the market returns to LOW risk, and will then be able to re-enter the market based on this overall market indicator. The individual trade signals will appear and will be given a position size based on the current risk of the market.
We don’t know for sure when this will occur, but when it does we will be able to re-engage the market with a much higher level of confidence than those traders who are unaware of the impact of volatility, and who are jumping in and out of trades with no real trading plan. An appreciation of volatility and the impact it has both on markets in general, and on the results of individual traders is vital to your long-term success as a trader and investor.
It’s interesting to compare the ATRVE in the periods preceding both major events. In 1987 there was no appreciable build-up in ATRVE before the cataclysmic fall of Oct. of that year, whereas the steady build up of instability leading to this years plunge stands it in complete contrast to that instance.
A simulated back-test of the SPA3 portfolio during 1987 would be worth having a look at.
You point out the abnormal volatility and the need to reduce exposure to the market to reduce drawdown.
Despite this and with no obvious turn upwards in the market, my MPS is buying again.
All buys are showing a loss and in and out of WOW in 9 days for an 18% loss!
Maybe you do need to “test” the market from time to time.
I just wish it wasn’t my money doing the testing.
It is interesting to note that many trading systems use volitiliy of a multiplier of the ATRVE to calculate profit target exits and stop loss positions. These systems trade seem to work well the volitility is low but struggle or simply implode as the volitily increases. By way of an illustration if BHP was trading at $30.00 and the ATRVE was 1% and we used a mutiple of three we are looking for a 90 cent move the same trade with an ATRVE 10% means the profit target is now $9.00. the probably of this trade being successful is i think unrealistic.
Isn’t it also a choice to simply not enter any new trades whilst the market is in a High risk phase ?
What is obvious is that this event is unprecedented. While commentators scrabble around looking for previous events to compare and relate to, the fact is there is none. Equity markets don’t actually have a very long history, and are still in a developing phase. Massive deleveraging continues to drive selling with no end in sight, and no indication of how much more needs to take place. However, consider this: the previous bull market was driven by levels of leverage previously unseen, both consumer, government and business. Wealth has been decimated in these sectors, and, when the bottom does come, the leveraging will simply not be available to fuel a new bull market. This may take many years to rectify itself. From a pracical trading point of view, most long positions taken in more than 1 year now, have been smashed…every rally has been a sucker rally.Why fight the trend, it has and still is down. There will be more company failures to come, US autos and banks are just hanging in there as we speak. So, having sold all my stocks earlier in the year, I don’t feel I have missed out on anything, and will wait for the market to actually prove a reversal, rather than get caught trying to predict it. If I miss 10-15%, so be it. As they say “fools rush in, where wise men fear to tread”.
Reply to Comment by Andrew:
“A simulated back-test of SPA3 portfolios during 1987 would be worth having a look at.”
We have the tools to do this but unfortunately not the data at the moment. We are working on getting access to an extended ‘research’ database that has no historical stocks deleted from the database as our ‘research’ database only goes back to 1999. Of course the database also needs to be adjusted for splits and consolidations.
Using a current ASX database would have too few currently listed stocks that were around in 1987 to make any research valid.
Regards
Gary
Reply to Comment by Eric:
“You point out the abnormal volatility and the need to reduce exposure to the market to reduce drawdown.”
SPA3 portfolios (incl. MPS portfolios) have reduced exposure and have been around 30% invested, on average, for many months now.
“Despite this and with no obvious turn upwards in the market, my MPS is buying again.”
When the market does turn upwards it won’t be obvious that it should. Despite the buying, SPA3 portfolios are still well below 50% invested. The buying is a result of following rules which over the long term lead to outperformance of the ALL-ORDS. Even in drawdown performance is far better than the ALL-ORDS. Relative performance is what needs to be focussed on. All too often investors are happy with relative outperformance when markets are rising and then in falling markets measure their drawdown in absolute terms.
Regards
Gary
When everyone is making money all are happy when we have times like this we have discontent.
A wise man once said EVERY ADVERSITY CARRIES WITH IT THE SEED OF AN EQUIVALENT OR GREATER BENIFIT!!!!!
Yep we are all hurting, but from this dreadful time has come the SPA HEDGE. Personaly I think the current market conditions are worth goimg through simply because it caused the creation of such a fine stratigy.
Thanks Gary for continuing to refine your edge and please keep up the good work
Reply to Comment by Otis:
“Isn’t it also a choice to simply not enter any new trades whilst the market is in a High risk phase ?”
Not entering trades during SPA3 High Risk Market periods is defined by SPA3 Risk Profile 1. The MPS portfolios use Risk Profile 2. Over the long term Risk Profile 2 will outperform Risk Profile 1 but not all investors have the same requirements so it shouldn’t be assumed that outperformance is everybody’s #1 investing requirement. Over the last 12 months Risk Profile 1 has outperfomred Risk Profile 2 by a country mile as Risk Profile 1 has been 100% in cash for all bar 8 weeks over the last 53 weeks.
Whilst SPA3 Risk Profile is a choice it is one that should be chosen on a consistent basis and Risk Profile’s shouldn’t be chopped and changed at a whim or decided upon when each High Risk Market comes around. Which Risk Profile is used must be committed in writing in each active investors Trading Plan.
Regards Gary
Reply to Comment by Grant:
“What is obvious is that this event is unprecedented.”
The event is certainly unprecedented but the market’s reaction is not. What is more important is that just about every major bear market has been caused by unprecedented events. From that viewpoint this bear market is not that diferent from previous bear markets. Sure the size of the fall has few precedents with the ALL-ORDS down around -53% from peak to trough but afterall it is just downward price action.
“Massive deleveraging continues to drive selling with no end in sight, …..”
There are far more variables at play in markets than any one individual or team of individuals can comprehend. Once an investor comprehends this fact then they understand that looking at any few variables (which will always be a subset of all the variables) and considering what affect they may have on future price movement is a futile exercise. This is why objectivity and a neutral mindset is required. Only then can consistency and openness to opportunities be achieved.
“….will wait for the market to actually prove a reversal, rather than get caught trying to predict it. If I miss 10-15%, so be it. As they say “fools rush in, where wise men fear to tread”. “
Waiting for the reversal is key as long as active investors have an unambiguous definition of what the reversal looks like, that is, their criteria that define the reversal in their investing timeframe, and then act on it when it occurs. Also key are their money management rules that define what their level of exposure is and will be during rising and falling markets.
All active investors will have a different definition of what “rushing in” is for them depending on the timeframe of their investing approach. Would you say that Warren Buffett has rushed in committing multiple billions over the last few weeks?
Regards
Gary
An unrelated question: What is SIROC?
The SIROC is a momentum indicator it stands for Smoothed Indexed Rate Of Change because it is smoothed and indexed it has a smooth cycle so it is very easy to read and a lot less subjective than other momentum indicators
Reply to comment from Grant W.
As they say “fools rush in, where wise men fear to tread”.
So, is Warren Buffet a fool ?
Warren Buffett has access to deals that we do not; read into the details of the buy into Goldman and you will quickly see it is not the sort of deal that you nor I could put together. His actions are by and large irrelevant to us.
I am still of the mind that it will be very clear when the “turn-around” will come because you can simply go back to basics. XJO will move above 30 week MA, share price decimations will no longer fill the news and people will start speculating off the back of low interest rates.
Gary you hit the nail right on the head so many of us are like deers in the headlights ( in Australia its usually rabbits )
Your post has made what is going on so much clearer it puts all into perspective in a logical manner.
For me I am spending this volitile time testing and writting a trading plan I figure if I don’t get caught again I have learnt a valuable lesson and the pain becomes all worth while.
One thing is sure the BHP method is not working in this market (BUY HOPE PRAY )