Day Trading and Volatility - Fact or Fiction?
March 29, 2004
We hear it daily on CNBC, read about it in the Wall Street Journal, and hear system developers often begging for its return. What is it? Volatility. Is volatility really the key to day trading system's returns. Will higher volatility mean more profits for day trading systems? While the conventional wisdom holds that volatility is very important to day trading systems, we're not so sure.
The first questions to ask are what is volatility, and how do we measure it? Investopedia.com tells us "volatility is a statistical measure of the tendency of a market or security to rise or fall sharply within a short period of time." The logic for this being a "good thing" for day trading systems such as Compass is that the more a market moves, the more opportunity there is to profit from such a move.
How do we measure volatility? Statistically, volatility is usually measured by taking the standard deviation of returns. Generally speaking, an annualized standard deviation of 10% would imply that approximately 2/3 of returns should be 10% higher or lower than the average return.
Investors and traders usually opt for different measures of volatility, however; the most popular of which is the Chicago Option Exchange's VIX indicator. The VIX is a measurement of sentiment on U.S. equities that the CBOE introduced in 1993. Derived from S&P 500 index options prices, the VIX is designed to reflect investors' consensus view of stock market volatility over the next 30 days. For the more technically inclined, the VIX represents the implied volatility of a hypothetical at-the-money OEX option.
Because investors buy protective puts in droves when the market is in a steep decline to protect from further declines in their portfolio's value, a high VIX reading usually represents increased investor fear and occurs during times of market turmoil. A low VIX reading implies everything is rosy, and investors are getting complacent in their need to buy protection against declines. (As an interesting side note, the CBOE released a new VIX futures contract on Friday, starting off with 449 contracts on the first day.)
The next measure of volatility used by professional traders is the Average True Range, or ATR. This is a technical indicator which is quite simply a measure of the difference between a day/month/year's high and low. Measured in absolute terms, the number is always positive, with a greater number implying a greater range of prices and usually occurring at market bottoms when investor's panic. A small ATR is usually a sign of a consolidation period.
From a day trading system perspective, a small ATR makes it very difficult to make money in dollar terms. For example, if the ATR is just 7 points, what percentage of that range could a day trading system expect to capture. It is unrealistic to expect a system to buy the low of the day and sell the high of the day to capture the entire range, thus a more realistic number may be say 50% of the range. At an ATR of just 7 points, 50% of the range is only 3.5 points, or $875. Those expecting to strike it rich day trading would need a whole lot of $800 trades to make their millions. Compare this with an ATR of above 20, where 50% of the range would net a system over $2,500 and you can start to see the argument that day trading systems need high volatility.
To put this theory to the test, we looked at the correlation of four day trading systems (Compass, R-Mesa, Daybreaker, and Early-Bird) and one swing trading system (I-Master ES) with three different volatility measures.
The table below shows the results of our testing, and the conclusion that the much hyped link between day trading returns and volatility may be just that - hype. Not seeing any statistically significant results in the comparison of the monthly percentage change of each system with the percentage change of each volatility measure, we expanded our test to look at the three month change (3 mo) and six month change (6 mo) of both the volatility measures and the systems. This again showed seemingly insignificant results.
Unfettered, we approached the test another way and asked what is it that really helps day trading systems, and answered "follow through" While this is a moving target of sorts and difficult thing to measure, the ADX indicator is supposed to give a reading of a trend's ability to "follow through" or "fade". The last portion of the table shows that the ADX was an even poorer fit to explain day trading results, again showing statistically insignificant correlation readings.
A truer test may be the correlation between the ADX of the S&P 500 on an hourly basis with the daily results of each system, as it is really the markets "follow through" within the day's trading that benefits a day trading system, not the market's trendiness from month to month per se. This test proves a bit more difficult, however, and will have to wait for a future newsletter. For now, suffice it to say that the pundits who ascribe blame for a particular day trading system's woes to volatility may want to look for a different scapegoat.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can
carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for
everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading
losses are material points which can adversely affect investor returns.
Feature | Week In Review | Chart of the Week |
Feature | Week In Review | Chart of the Week |
Except where noted, the below Profits/Losses are based on closed out trades. $50 per R/T commission included ($30 per emini) Percentage gains based on developer recommended initial balances as listed at www.attainaccess.com.
**Swing Trading**
Swing trading systems, and most notably I-Master, have been on a wild ride so far in 2004. Just a few weeks ago, I-Master ES was down 113.40 points for the period from October of 2003 through January 2004. The comeback began on February 24th, as the system took in profits of +537.50 per contract (11.75 points) and hasn’t looked back since. Since then, I-Master ES has reclaimed 53% ( 59.63 points) of the losses taken between October 2003 and January 2004.
What factors have contributed to the recent success? It’s hard to pinpoint anyone reason, but trading conditions, including volatility and volume, have improved giving the system ample opportunities for success in the SP market. Last week I-Master ES, NQ, e-RL, and e-MD all enjoyed profitable trading with I-master ES making +$526.50 per contract, I-Master NQ making +$810.00 per contract, I-Master e-RL making +$1105.00 per contract, and I-Master e-MD making +$719.00 per contract.
Other swing trading systems had success as well, especially the Delmar system, which took profits of +$995.00 per contract in the ES, +$690.00 per contract in the NQ, and +$200.00 per contract in the e-RL. Tzar had a quiet week continuing to hold long in the ES and e-RL while holding short in the NQ.
**Day Trading**
Unfortunately, the success of the swing trading systems did not transfer over to many day trading systems as most had a losing week. Grabbing headlines once again was Day Breaker SP as the top performer, making +$2475.00 per contract after trading twice last week. Day Breaker has enjoyed a very successful run so far in 2004 making +42.40 points in the last three months. Most of Day Breaker’s success can be attributed to its ability to take profits in choppy market conditions. The only other system to take profits was a new system at Attain, RC Success ES, which made +$402.50 per contract after two long trades last week.
Most other day trading systems found the going quite a bit tougher as market conditions did not favor systems looking for extended intraday market trends. Systems that had losing weeks included Blue Wave Zones SP which lost -$675.00 per contract, R-Mesa 5 SP which lost -$925.00 per contract, LTS Barracuda SP which lost -$2467.50 per contract, and Compass SP which lost -$4187.50 per contract. The losses could have been worse but a big upward trend in the market on Thursday allowed several systems to earn back a portion of previous losses.
**Long Term**
Long term, multi-market systems enjoyed a quiet week for the most part. Large downward moves in the crude oil and U.S. Bonds erased a good portion of open trade profits unfortunately for systems such as Andromeda, Trendchannel, and Checkmate. Andromeda took the biggest hit as it is long in the 30 year bonds, 10 year notes, 5 year notes, muni bonds, and crude oil. Over all the system lost approximately $10,000 in open trade profits across these 5 markets.
Trendchannel also suffered with the system holding long in the ten year notes and crude, while Checkmate was holding long in the 5 year and 10 year notes. Overall these trades are still profitable for each system, however last week certainly will wipe some of the shine off each system's monthly percentage gains.
Please Login to: http://www.attainaccess.com for the latest updated statistics.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can
carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for
everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading
losses are material points which can adversely affect investor returns.