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Revisiting the impact of these markets on traders and investors

The other day I asked the question “How have these markets impacted your trading?” (if you haven’t already left your thoughts, please feel free to do so). I was very interested to see the number of responses which were variations on the “I’ve kept to the sidelines” theme. It seems like the volatility of the markets has driven quite a few traders away. The question is whether that’s a temporary thing until the volatility drops back down, or whether it’s a more permanent development.

From the perspective of a trading educator, I like to hear that traders who are struggling with the markets have pulled back and are using the opportunity to become more knowledgeable about things, leaving their money out of harm’s way. That’s a very intelligent and rational way to go about things. I don’t recall who it was, but one of the traders interviewed in Market Wizards said something to the effect of “When you don’t understand what’s going on, get out.” And of course if the volatility means you would have to take more risk than you should to make a trade, then you shouldn’t make the trade (which of course also brings back the question of capitalization levels).

Of course not all those who have pulled their money out of the markets are traders who will return when conditions are better. Many are people who feel burned. It’s like the exodus after the Crash in 1987 and the bear market at the start of this decade. Both drove investors out for years. This chart highlights that very well:

The Normalized Average True Range (N-ATR) below the monthly S&P 500 plot tells us how much volatility there is from month to month. We can see that it dropped off very significantly in the years after the ’87 Crash, and then again after the Tech Bubble burst. Given how volatile the markets have been of late, as the N-ATR line shows, I wouldn’t be surprised to see another period of relatively quiet trading once we get past this period of uncertainty about the markets and the global economy.

With that in mind, it’s worth looking at your trading strategies and evaluating them as to how they may respond to changing circumstances. That’s something you should be doing periodically anyway.

By John

Author of The Essentials of Trading

5 replies on “Revisiting the impact of these markets on traders and investors”

John,

The thing I find most difficult is how do you establish a limit, an N-ATR percentage where we stop trading. Also, if you are trading on daily data, am I supposed to check N-ATR on the same timeframe or may be longer ones? Ideally this should be part of an automated strategy, but I am not sure which way to go in terms of setting the filters.

Forgot one: Is it possible to use this indicator for profit by itself (as opposed to using it for filtering out volatile periods)

Rod – ATR (the base, not the normalized version) is used by many people for the placement of stops, and in some case targets. Van Tharp discusses this sort of thing in Trade Your Way to Financial Freedom. Also, ATR was used by the famous Turtles in their position sizing, as Curtis Faith talks about in Way of the Turtle. I recommend both books.

As for whether I can suggest a specific N-ATR beyond which you don’t want to trade, I can’t. My general point is that you should be adjusting your stops to account for the volatility in the market (not using the same old fixed ones when vol is up, for example). That, in turn, impacts your position sizing, maybe to the point where you cannot do a certain trade because the risk implied by where you’d need to put your stop would be beyond your acceptable risk level.

Hi John,

What is the mathematical relation, if any, of normalized ATR to the standard deviation of daily price changes?

Rod – ATR looks at period ranges, not closes. As such, there it isn’t a direct relationship between N-ATR and the StdDev of closing price. For example, ranges could be expanding but close may not move far from it’s average. Or you could have the opposite where the close deviates widely from the average, but the period ranges are quite narrow.