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Reader Questions Answered

What’s going on with volatility?

Yesterday Michael Covel posted a reader question on his blog:

“As i am going through my different portfolios i am wondering what’s up with Eurodollar, seems to have extremely low volatility, much lower than another futures. Any idea whats going on?”

Covel, of course, is a big proponent of trend trading, having written Trend Following and also The Complete Turtle Trader, which is a look at the Turtles, who were very much trend traders. As a result, his fairly predictable response was “Who cares?”.

My own response to Covel would be that volatility was specifically included in the Turtle system, so it definitely matters. To the extent that someone could anticipate changes in volatility they can better manage risk.

Going beyond that, though, is simple market reality. I don’t know whether the person asking the question was referring to Eurodollars or EUR/USD (the Eurodollar term is sometimes wrongly used to refer to the currency exchange rate when it’s supposed to refer to US dollars on deposit outside the US). It doesn’t really matter, though. As my comparative volatility analysis shows, on a relative volatility scale, those two markets are low readings. So the answer to the question above is “That’s almost always the case”.

To address things from a fundamental view, if the questioner is indeed talking about Eurodollars, then it’s simple. US interest rate policy has been very stable for quite some time now (ZIRP), so there’s been no reason for short-maturity fixed income markets to show much volatility.

Categories
Trading Tips

Volatility Changes Across Markets

A recent blog post got me thinking about where volatility stands now compared to where it’s been. Here’s what I found for stocks and the dollar. Both of the charts below is a weekly which includes two measures for viewing volatility. Normalized Average True Range (N-ATR) measures average period high/low ranges (You can find articles I’ve written about N-ATR at Trade2Win and TASC). The Band Width Indicator (BWI) measures the distance between the Bollinger Bands, which is standard deviation of closing prices.

Dollar Index
Here we see that while volatility has certainly fallen well off from where it was during the worst of the financial crisis, it hasn’t quite got back down to average levels from before then. It’s worth noting, though, that volatility heading into the start of the problems in 2007 was ridiculously low. I don’t expect to see it get back to those kinds of levels.


S&P 500 Index
Volatility in the stock market, however, has now fallen back to about the same levels it was at during the middle of the last decade. This is something very important to keep note of because N-ATR tends to be low turning sustained uptrends, but rise into market tops.

Categories
The Basics

Ever Increasing Volatility in Forex

I came across a post in one of the groups on LinkedIn in which the author described the volatility in the forex market as “ever increasing”. That was a major case of hyperbole for someone clearly making a sales pitch of some point. I challenged him on the metric and 1-year standard deviation was suggested by someone else. I did a volatility comparison between markets a few months back which showed how low the volatility in forex is relative to other markets, but that only looked at 1 year worth of data. Let’s see what the patterns look like going back further.

I’ll look at the major pairs going back to the 1999 launch of the euro. Here’s a chart showing the trailing 1 year standard deviation of closing price. For ready comparison it divides the standard deviation of the last year’s worth of closing prices and divides it by the average closing price of that same period.

As we can see, volatility in the major currency pairs is hardly “ever increasing”. It most definitely spiked up during the financial crisis, but now it’s back down to its more normal range. USD/CAD volatility by this metric is actually lingering down near the bottom of its range for the study period.

Here’s a second way of looking at volatility – average daily range. This chart plots the running 1 year average daily range ( expressed as H-L/((H+L)/2) ).

Again, here we can see the impact of the financial crisis on daily ranges. And again we can see how the average daily range has been working back to more normal levels. It’s still running a bit high, but not outside the prior range.

So in other words, volatility is far from ever increasing.

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Trading News

Expanding Margin Rates in Silver

The CME Group yesterday announced that it would be bumping the margin on the silver futures contract from $5000 to $6500 effective today. That’s a 30% bump, which no doubt has impacted some traders. In making this move, the exchange increased the margin from about 3.6% (at current prices as I write this) to about 4.7% (a silver contract being 5000 troy ounces). The chart below explains the move.

Silver prices have jumped about 50% since the end of August. Back then, the $5000 margin was about 5.4%. Volatility was also significantly lower. Now we’re looking at a much higher price and significantly higher volatility. The futures exchanges will make adjustments to margins based on both factors as they see fit. It’s interesting in this case, though, that they haven’t bumped it up to the approximate level it was before.

Categories
Trading Tips

Watching for a Market Explosion or Implosion

I’ve written on several occasions, including my first ever article published in Stocks & Commodities, on the subject of using Bollinger Bands in regards to identifying trends, especially the early stages of them. Basically, I use the Bands to look for situations where a market is ready to make a big move. In reviewing the charts this morning I noticed just that sort of situation in the stock market. Check it out.

SPX120709

Notice how tight the Bands have gotten thanks to the relatively narrow range the market has been in the last few weeks. The BWI indicator at the bottom of the chart (Band Width Indicator) says they Bands are about 2.8% wide relative to the 20-day moving average. That’s the lowest BWI reading in a while. The Volatility Reference Indicator (my own creation) tells us where the current Band Width is in relation to its extreme readings for the last year. It’s at 0, meaning the Bands right now are the narrowest they’ve been in at least a year.

All this means we should be looking for something big to happen. The narrower the Bands get, the more explosive is the move which follows them. If stock volatility expands rapidly (which is what an expansion in the Bands from the current narrow reading would mean), you can be sure similar types of action would be going on in the dollar, bonds, and commodities.

Alas, the Bands won’t tell us which way the eventual volatility expansion will take the market. Other tools are required there.

Categories
The Basics

Looking at Volatility Across Markets

The other day I commented on a post on a personal finance blog. The article was an introduction to forex. I won’t link to it here because it was very poorly done, falling short on many points. One of the things that tripped off alarm bells early on about where the post was going was this statement:

However, it is important to note that forex trading is rather risky, and the currency market is quite volatile.

All trading is rather risky, so I won’t address that particular point. I will, however, speak to the issue of the currency market being quite volatile. Statements about the forex market being more volatile than others are made all the time – almost always by folks who are putting forex trading down in some fashion or another. As I’m going to show you, the numbers make it pretty clear that forex is in fact on the low end of the volatility scale when looking at all markets.

Here is a look at the last year worth of volatility in forex rates

Pair Daily StdDev Avg Daily Rng
EUR/USD 0.93% 1.41%
USD/JPY 0.91% 1.45%
GBP/USD 1.00% 1.65%
USD/CAD 1.02% 1.60%

The first column is the standard deviation (a commonly used volatility metric) of the daily % change for the one-year period beginning November 1, 2008. The second column is the average daily range, with each day’s range being expressed as a % of the prior day’s close ( [H-L]/C ). I went with % changes and ranges to make things directly comparable across markets. So from this data we can see that USD/CAD tends to see the biggest daily changes, though GBP/USD tends to have slightly wider daily ranges.

Now let’s compare that to the major US stock indices.

Index Daily StdDev Avg Daily Rng
Dow 2.01% 2.41%
S&P 500 2.26% 2.60%
NASDAQ 100 2.18% 2.69%
Russell 2000 2.89% 3.28%

Here we can see about what as we would expect in terms of the small cap Russell index being the most volatile in terms of both price changes and ranges.

And how about individual stocks?

Stock Daily StdDev Avg Daily Rng
IBM 2.18% 2.85%
GE 4.20% 5.59%
AAPL 2.66% 3.44%
GOOG 2.51% 3.33%
AMGN 2.33% 3.03%
XOM 5.95% 6.66%
JPM 2.23% 2.88%
KO 1.74% 2.45%

All of the above are clearly large-cap stocks which would generally be expected to show less volatility than mid- or small-cap stocks (as witnessed by the higher volatility in the Russell index). Even still, with the exception of KO, they are all much more volatile than the forex pairs.

So what about commodities?

Commodity Daily StdDev Avg Daily Rng
Gold 1.61% 2.38%
Oil 4.35% 6.01%
Nat Gas 4.91% 6.54%
Corn 2.70% 3.83%

Again, the commodities are clearly much more volatile on a day-to-day basis than are forex rates.

Now to add in a market that’s considered the least risky by many folks – interest rates.

Instrument Daily StdDev Avg Daily Rng
Eurodollar 0.05% 0.06%
2yr Treasury Note 0.13% 0.18%
10yr Treasury Note 0.63% 0.92%
30yr Treasury Bond 0.99% 1.50%

I’m using the futures for the prices above. Finally we have a market where volatility is lower than forex! As you can see, the shorter maturity instruments (Eurodollars are 3mo) are calm compared to the others we’ve looked at here. Bonds, though, are in line with the volatility readings we see for the forex pairs.

So the bottom line is that not only are forex prices NOT the most volatile, they are actually on the lower end of the spectrum when looking at available markets. The numbers demonstrate it pretty clearly, even in a 12-month period which has seen its fair share of volatile trading.

Now granted, the application of leverage in forex creates the opportunity for very high levels of volatility in one’s trading account – but that’s not the market’s fault. Traders don’t need to use leverage. You can trade forex without it.

Categories
Reader Questions Answered

A Reader’s Story About a Stop Getting Hit

A reader named Susan left this comment recently on the Some Not-So-Great Tips for Using Stop Orders post I wrote a while back. I think it does a great job of highlighting a situation – or at least a type of situation – which new traders find themselves in where stops are concerned.

I have a question, as a newbie to trading, and using things like stops, etc. We had purchased a stock that started to go up… after it was in profit, we placed a stop order, for about .15 below the current trading price. Until our stop order, the stock was steadily (fairly quickly) headed upwards… but just in case we were not at the screen, we thought we would try a stop order.

I can’t figure out if we did something wrong, or what happened. But this is my perception of what happened -… within seconds of my placed stop order, the stock price steadily dropped to my exact stop price, my shares sold, and then headed right back up to the previous high, to go on higher. All within 5 mins or less.

I am aware stock prices fluctuate, but to my eyes, it seemed my lower “steal of a sale price” was noticed, somehow snatched up, and thing continued on upwards.

Prices can fluctuate, and I guess coincidences can happen. Or the more obvious answer may be that I didn’t place the order correctly, or understand what was to happen once I did.

My understanding was that this price was to execute only if the stock (naturally) dropped.. not to sell at this price immediately (which would otherwise seem kinda MARKET….).

I know this isn’t the case, but it seemed as if someone could read our price, got the stock prices to go down, grabbed ours at a “deal/steal” and then got the stocks to start moving up again. But I can’t grasp what did happen, likely because I have no experience, so likely a misunderstanding of stops altogether, or movement of stocks, in the least.

Any help in understanding this? Thanks so much for your time.

OK. We don’t know what stock Susan is talking about here, so we don’t have a proper frame of reference for the price movements likely to be seen. That said, when I read that she was using a stop 0.15 below the market I just about fell over. I think most experienced stock traders would agree that this is probably way too close. A move like that for most stocks is little more than statistical noise. You’re almost guaranteed that it will get hit just as a result of normal price volatility created by the interaction of buy and sell orders hitting the market – or by news induced price swings.

Tightness of the stop aside, anyone who’s been in the markets for any length of time has seen at least one instance of their stop getting hit and the market basically turning right back around. It’s very annoying, of course, but if you need to expect it. All you can do is review the analysis you did in placing your stop there and see if that was the right decision given what you knew at the time.

There are, of course, situations where stops and other standing orders do get “run” by the market, where large players attempt to create price movement to trigger the execution of those orders. That really only happens when there are large numbers of stops all in a very obvious location, though. Chances are if you’re stop is hit it probably wasn’t any conscious act.