Saturday, May 17, 2008

The Psychology of Market Volatility


The chart above displays the relentless decline in option-related volatility ($VIX) from the March stock market lows to the present. But how does this decline in volatility affect traders and their psychology?

I ask the question because three observations have struck me in the past week:

1) An increasing number of traders have contacted me, indicating frustration with their (day) trading, including greater losses during the afternoon trade;

2) An increasing number of traders have contacted me, indicating that they have been "too aggressive" in trading the current market;

3) My own trading performance, which had been quite consistent through 2007, turned flat for several months before resuming consistency in April and now becoming quite positive in May.

I don't think these observations are unrelated. The day traders I talk with benefit greatly from volatility. When markets become less volatile, they find themselves going after large moves that never materialize. This leads to frustration and over-aggressive trading.

I, on the other hand, tend to be quite risk averse in my trading: a peak-to-trough P/L decline of 3% would be a major deal for me. When I detect large volatility in markets, I immediately cut my size to standardize my returns and I trade less. Where the traders I talk with experience volatility as opportunity (and indeed take advantage of it), I experience it as risk (and benefit far less from it).

Conversely, as volatility drops in the market, I am comfortable with the market conditions, take small profits frequently, and build my account. Where the traders I talk with see the low volatility environment as low opportunity, I experience it as low risk. As soon as the VIX moved back into the low 20s, I was in my glory. The traders, on the other hand, were finding it more difficult to participate in large moves, frustrating their ambitions.

The point here is that volatility affects the psychological environment of trading. Depending on our risk appetites, we will respond differently to volatility regimes--and that will likely affect our trading performance.

A few statistics will highlight the psychological importance of volatility. I went back to January, 2008 (a higher volatility environment) and found that the median 30-minute high-low range for the ES futures was .60%. I then looked at May, 2008 to date (a lower volatility environment) and found that the median 30-minute high-low range for the ES futures was .29%. In other words, at a 30-minute time frame, markets are moving half as much now as they were in January. Is it any wonder that traders looking for big moves are becoming frustrated?

Traders don't realize that volatility scales at every time period. If we have lower daily volatility (as the chart above depicts), we will have lower volatility for every intraday time period. Whatever our average holding period might be, the market will move less in a low VIX environment than a high VIX one. That greatly affects trading behavior:

* It means that any standard method of placing stops and targets will perform poorly as volatility changes dramatically. When volatility rises, we will tend to have our stops too close and get whipsawed frequently. When volatility falls, our targets will tend to be too far away, leaving us in a situation in which we make money on trades, only to see the trades reverse before we are ready to exit.

* It means that any standard method of sizing trades will lead us to go through periods of high performance volatility as markets become more volatile. These large P/L swings can create considerable distress for risk-averse traders (like myself). On the other hand, the standard method of sizing trades will lead to lower performance volatility as markets become less volatile, leading more aggressive traders to become frustrated with the truncated range of their returns.

Markets change how they trade periodically. What we've been seeing since March, 2008 is a noteworthy change in market direction, themes, and volatility. The ideal is to recognize these shifts as they are occurring and make mid-course corrections as promptly as possible. This is especially difficult for newer traders, who lack the database of personal experience to know how to adjust to radically different trading environments.

I'm not going to name names, but if a "Market Wizards" book were to be written now, surprisingly few of the people featured in those earlier volumes would qualify for chapters today. It's difficult to succeed at trading, but--given rapidly changing market conditions--even more difficult to sustain success. It's not good enough to find winning trading techniques; one has to continually adapt these techniques to an ever-changing environment.

RELATED POSTS:

Anticipating Volatility

A Psychological View of Volatility

Relative and Absolute Volatility

An Indicator for the Coming Day's Volatility

When VIX Becomes Volatile
.

8 comments:

Banker said...

I totally agree with you. I have been trading for 20+ year's. My style today is much different from when I started. I have seen many, very good traders fade away because they refused to adapt.

Great post, I enjoy reading your blog.

markus said...

As you I belong to the more risk-sensitive (minority - I guess) of traders who were struggling with high vola. January I was flat before commissions, but February and March were quite good. My experience in January was that prices were cutting without hesitation through restistance/support levels. You could feel the market wobbling - a lot of uncertainess - searching for a new wide range value area. I was struggling with my trading approach and had to adapt my tight stops, but even then it was very difficult. Sometimes I thought these equity indices act like grain futures as they were spiking some days in January. It was a different market but it did not last long.

Cheers,
Markus

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fire up your rear said...

it's interesting you have heard alot of complaints from traders who are frustrated with the markets intraday. because i've seen this coming several months ago.

have you noticed the number of retards cnbc has brought into the market? with the likes of jim cramer or fast money or whatever the hell they air on their network, lots of 20 somethings or old investors want their hands in trading. they hear options trading or technical analysis and they think they have obtained the key to market success.

you can see this from the amount of technical analysis related discussions on chat rooms, message boards, all across the internet basically. with so many books and very easy access to information on the internet, many people can start to dip their toes in.

but as you know, known information is useless information. i have never seen such a time where so many people were paying so much attention to oversold stochastic and the downtrend line on the s&p that we have just broke several weeks ago

EVERY GODDAMN RETARDS were expecting a turn back down when the markets touched the trendline. and that is a very good sign that it probably will not happen.

you have reasoned that the reason why traders are having difficulty during these recent times is due to low volatility. and that is something i have not thought of but surely understandable.

but i was thinking it was due to the many influx of new traders who are simply using the same strategy we have been using.

just look at the commercials on tv. the brokers used to advertise about retirement and long term investments.

now? they are talking about short term trading and options trading. they have commercials where a freaking baby is trading or a 20 something is trading behind a multi monitor setup with a xbox 360 sitting next to it

can you believe that? that is the kind of environment we are in. everyone wants to get rich, and do so quick

since it's so hard to get jobs for new college graduates, this risky and potentially high reward nature of trading can be especially appealing, which could explain influx of so many 20 year olds

the only thing that makes a successful trader is to anticipate other traders' minds, period. with so many information laid out for free on tv or the internet, we will be looking at a new market environment.

Created by: J. Barlow Smith said...

Hi Brett,

I really enjoy your Blog and I think you provide important information for traders.

I just wanted to make a minor correction on your post...

You keep referring to the VIX as volatility. It is not the volatility of the market; but the implied volatility of the options.

The volatility of the market is past. Implied Volatility is what option traders expect(future) by how much premium they are willing to pay for an option.

Anyways, Keep up the great work!

Barlow
http://jbarlowsmith.blogspot.com/

Brandon Wilhite said...

Brett,

I have no idea how this applies to day-traders, but as a swing/position trader what I've been doing is basically running two types of strategies. When volatility spikes in a major way, I've been selling options...with the trend (nobody wants to step in front of a bus). When volatility is down, then my regular delta-neutral strategies work just fine. This seems to be working well for me in the last 6 mo. as long as I remember to wait until we have a really major spike in vol. I got a little over-eager last month and got into a bad one, but luckily I was able to unwind without a loss.

Last year's craziness was hard on me, b/c I didn't have the options selling to fall back on at first. I think it would be really hard for a day-trader to run two strategies this way, since they don't have as much time to think about their actions.

Way said...

Brett,

Spot on with this article I think, I have noted the follow through has shrunk in the market and there are many impressive reversal moves going on.

I'm interested in how you position size based on volatility, have you expanded on this previously?

I had an idea to correlate my returns, which thrive when there is follow through with the VIX, then I read your blog and it covers everything I was thinking and then some, guess I should start reading your archives more closely!

Cheers,
Andrew
www.humblemoney.com

Brett Steenbarger, Ph.D. said...

Hi,

Thanks for the insightful comments on the post. I really like Brandon's approach of trading multiple strategies, and using those strategies to adapt to shifting market conditions.

My approach to position sizing is to take pretty much the same risk on every trade over time. That means that I tend to reduce my size as volatility increases.

Brett