This article was written by Kacy, a regular at our site. I thought it might be of interest to those on this thread.
Perspectives on S&P Volatility - A Look at the Forest
I have suggested in the past that it is very important to keep the market at "arms-length" in order to maintain perspective and psychological balance. This begs the question of how to accomplish this feat, and the answer is critical for traders and investors who want to master themselves and the markets in which they plan to make money. Note the emphasis on the word plan, for only those who develop logically consistent strategies for operating in the markets, and carry them out, are ultimately successful. Merely hoping for success leads to failure.
Perspectives Are Not All Alike
In thinking about how to keep the market at arms-length, comments from the NASA scientists (whose role in all this is described in the previous article) seem particularly relevant. In remote sensing from space, it is easy to get the wrong perspective for solving the problem in which you are interested. This problem of perspective arises from a mismatch between the information you collect and the questions you ask. In other words, when remote sensing it is easy to miss the proverbial forest by looking too closely for details of the trees, or to see the whole forest but be unable to tell what is happening with individual trees. The fault may partly lie with the limitations of technology, but just as often it is the result of political, budgetary, or psychological expediency.
When it comes to trading and investing in the markets, individuals can encounter similar perspective mismatches. One of the most common mistakes made by beginners is failing to identify a market and time frame that "fits" not only their financial situation and technical expertise, but also their personality. As discussed in the article Which Stocks are Worthwhile to Day Trade?, volatility and volume are two prerequisites for successful trading. But, markets with overall volatility are not necessarily uniformly volatile through time or when examined across different time frames. Failing to recognize this can lead a trader to participate in the market when volatility or volume falls below levels that are suited to their analytical tools and trading style. As an example, let us look at the most recent trading year for the S&P500 futures contract.
Viewing the S&P Forest
Below is a chart of the daily trading ranges for the S&P500 futures over all active days of the last four contracts. Given that this is daily data, it would fair to say that this gives a broad, forest-like view of the volatility of the market for that historical period. One thing to notice is that volatility has been fairly consistent over the last year, regardless of the media-touted thesis that volatility has been rapidly increasing. In fact, statistical analysis of the data suggests that average daily trading range is increasing at only about one point per hundred trading days. The Asian Crisis of last year did temporarily increase volatility, but it quickly returned to pre-crisis levels.
Assuming constant overall volatility, I calculated that the S&P500 contract has had a mean daily trading range of 23 points, or slightly less than 2 percent of the market level (see the chart below). This level is volatility is typical of recent years, but is a good bit higher than long-run historical standards and currently represents an average per contract trading range of more than $5,000 per day. The one-sigma band (or standard deviation about the mean), within which 68 percent of the volatility lies, suggests that the majority of days will present the opportunity to trade for some part of $3,000-$9,000 per contract - and this doesn't even account for the fact that on many of those days the market will fluctuate repeated between the high and the low. Given these kinds of opportunities, it is not surprising that retail trading of the S&P500 and e-mini contracts have exploded in recent years. When it comes to consistent, day-in-and-day-out volatility, the S&P500 futures contract beats all but a handful of stocks.
You Don't Have That Logging Permit Yet!
Does the fact that the S&P500 is volatile make it the right trading vehicle for you? The answer to that question requires close consideration of your trading style. Volatility is a double-edged sword, as the chart below indicates. When it comes to ups and downs, the S&P500 contract has more of them than a roller-coaster, even on a daily basis. Position trading this contract often takes more than a few bottles of Maalox, with severe and rapid account drawdowns to be expected at times for both short and long positions. For this reason, S&P500 position traders must be both financially and psychologically capable of entering into trades that may have logical stops 10 or 20 points away ($2500-$5000 per contract). Given a 1.5 percent equity risk rule, these numbers suggest that potential S&P500 position traders should have a minimum account size of $150,000 to $200,000 per contract traded (or $30,000 to $40,000 for the e-mini). Needless to say, few retail traders actually have that kind of account.
Because of the sheer amount of capital required to position trade the S&P500 futures in a risk-responsible way, many would-be intelligent speculators consider day trading this contract. Doing so can potentially cut capital requirements to more "reasonable" levels given that logical stops often occur only 1-3 points away from a trade entry. But, moving to the intraday trading environment raises question about intraday volatility - specifically, are all periods during the day equally volatile? Phrased another way, are there particular times during the day that offer better opportunities for traders? We will look at these questions in the next article on S&P volatility.
Charts have been posted to intelligentspeculator.com |
