Over the weekend Brett Steenbarger posted The Psychology of Market Volatility to his blog. He makes some very interesting observations about the way traders react to changes in volatility – or fail to do, more like.
I would be willing to bet that a great deal of the troubles traders have in sustaining consistent performance has to do with changing volatility. Markets change. They go through periods of high volatility, periods of low volatility, and those in between. And it happens in all different timescales. Some traders have strategies which work well in one environment and poorly in others. This is why there were some ringing the death knell of technical analysis in the first quarter of this year. Volatility had changed, dramatically altering the effectiveness of methods traders use.
The varying volatility landscape is a major part of why I have never been an advocate of fixed sized stops. A stop of a certain size will have different chances of being hit under different volatility conditions. If you use the same size stop all the time, you willÂ take more losses in high volatility periods and you will probably end up trading too small in the low volatility spells.
All of this is why you need to be conscious of what the market is doing. Volatility shows persistence. That means markets at low volatilities tend to stay that way, and the same with high volatility markets. Of course there will be transitions, but normally you can see that if you’re paying attention to things like the width of the Bollinger Bands or the Average True Range indicator.