On the face of things, these 2 myths seem logical, but they are not. And once you learn why, you will have a whole new appreciation for volatility and how to use it to your advantage.
MYTH #1 if your strategy consistently loses 70% of the time, all you have to do is switch your orders, and buy, when you would normally sell. Then you would be a 70% winner.
MYTH #2 If markets are random, just flip a coin to decide when to buy or sell, heads you buy, tails you sell. You’ll be right 50% of the time.
Both of these sound correct from a statistical point of view, however each of these myths is not taking into account some very important information that is present with every trade you make.
Ok, let’s suppose you’re trading Apple and your strategy calls for a 10 cent stop loss. We can see from this price chart from yesterday (October 14th) that any trade with a 10 cent stop loss would have been stopped out on a regular basis. That’s because Apple’s price ranges 30-40 cents throughout the day.
We can see this by looking at the Average True Range (ATR) indicator, which measures volatility and is an excellent way to get a handle on setting an appropriate stop. The ATR was very high in the morning, then settled out later in the day…this is quite typical.
The ATR was at a peak of about 33 around 10:30 AM, then finally settled to about 20 for the remainder of the day. The value of the ATR is in cents, measured as an average range using the previous 14 bars.
Now let’s consider the coin flip myth. While it’s true that a trade taken anywhere during the day has approximately a 50% chance of going up or down, when you add in the 10 cent stop, and consider the amount of volatility, that 50% chance goes down to 0%.
Now, if you were to widen your stop to be something close to the ATR, then we would start approaching that 50% theoretical rate of choosing the right direction. And the wider we make it, the closer we get. So, by having a tight stop loss, you may think you are controlling risk, when in fact you are guaranteeing that your trade is going to lose nearly all the time.
Even if we took on myth #2, and switch our buy and sell orders, that pesky volatility, and out tight stop loss, would give us pretty much the same result, a big losing trade, one after the other. Even if the trade was perfectly timed.
So, what’s the solution?
You need to know where volatility is at all times. Not only will it tell you where your stop needs to be, but it will also clue you into an appropriately sized position. In general, higher volatility means wider stops and smaller positions, and low volatility is the opposite, smaller stops and larger positions.
These dynamic adjustments will move you closer to the trading sweet spot.
As far as myth #2 is concerned, the coin flip…volatility is only one of the factors you must consider. You would have to time your trades perfectly to gain an edge, a random trade simply wouldn’t cut it. If you go long at the daily peaks, you’re gonna suffer.
So, one way you can overcome this is to measure momentum, in an attempt to find the peaks and valleys of price action. Of course you’ll never be perfect, pin pointing the exact bottoms and tops of pivots is virtually impossible. So, what do you do?
Let price come to you, and except the fact that you are going to lose some trades.
Use momentum to get you somewhere in the ball park for timing your entry, and ATR to adjust your stop and position size.
You also have to accept that when you settle on some value for momentum, you might not hit an extreme during the day, and thus there will be no trade setups. That can be frustrating, but you have to suck it up and take it. On the other hand, there will be days when the market simply goes nuts, and runs straight up or down, and you never find a spot to enter, or you enter what your indicator says should be a top, but then it just continues going up.
Again, you need to come to grips with the fact that you can’t win every trade. You may not even be able to win 50% of the trades you take. So, long as your winning trades make more money than your losing trades, you’ll make money. But that’s easier said than done.
Is ATR the only way to measure volatility?
The ATR measures volatility in terms of price action, but that’s only part of the available information that makes up the volatility of a security. Let’s face it, using 14 bars before you can determine where volatility is can make your trading choices always behind the gun, lacking real time info.
Another way to assess volatility is through liquidity. You measure liquidity in terms of the size and frequency of limit orders placed by other traders waiting to take your trade. This is a far more complex topic that I will leave for another email. But let’s just say that there’s a direct correlation between the amount of liquidity and the amount of volatility.
At least now, you have a new understanding of volatility, and some ways to use it, and hopefully a new found skepticism. Sometimes things that seem logical, are missing key bits of information. Do your homework, and preserve your capital at all costs, before you chase myths that promise easy profits.