Friday, June 20, 2014

Where are the trades? An answer in one chart

This has been the season of a shrinking trading pool. There are plenty of signals. Most of them,  these days, are bullish. But on close examination, the charts show a lack of conviction. The signals are bullish but the charts are only marginally so, and in many cases, quite bearish.

And so I find myself, day after day, eyes glazed, a picture of frustration, as I sit running my daily analysis of nearly 4,000 symbols, only to conclude, in the end, that there's nothing there for me to trade.

Where in the world have the trades gone? The answer is simple, and can be illustrated with a single chart: This one. It's a 20-year chart of the VIX, which traces the implied volatility of the S&P 500. Each bar represents one month.

Click on chart to enlarge.
VIX 20 years monthly bars
The conventional wisdom in the markets is that implied volatility -- the VIX -- is a contrarian indicator: High volatility is bearish and low, bullish.

This is certainly true, to an extent. But it is also true that high volatility means it is easy to make money, and low volatility makes it very difficult to do so.

This is Trading 101: If prices don't move, then there is no profit. The greater the movement, the greater the chance for profit.

This is especially the case for momentum traders like me. Without momentum, under my trading rules, there is nothing I can trade. I can make money in bull markets and bear markets, but I need the price movement in order play.

Implied volatility on the S&P 500 is at its lowest level in more than seven years. I've marked that level, 10.34%, on the chart below in red.

Note that this is only the third period in two decades that volatility has fallen so low. That last two were in 2007 and then back in 1995.

So the answer to the question "Where have the trades gone" is that they have melted away with the volatility. The implication is that when volatility returns, so will the trades.

The other lesson of the chart is that volatility over the long run traces a sideways path. I've marked the approximate peak for the last two decades, excluding that of the Great Recession. Volatility has returned to that level six times, or seven if the Recession is included.

If the 10% level, give or take, is rock bottom for the VIX, then the chart shows that we're due for a bounce. The technical term for this is "reversion to the mean", sort like a horse returning to the paddock at night. The VIX, like a fine old horse, tends to come home to the mean every time.

And if implied volatility is a contrarian indicator, then the market is due for a fall within a year, as the VIX rises.

In the meantime, my rules will steer me away from marginal trades and only allow me to trade on high-quality charts. If those rules mean I have very few trades, then so be it. Far better to have a briefcase of good quality trades then a truckload of bad ones.

By Tim Bovee, Portland, Oregon, June 20, 2014


My shorter-term trading rules can be read here. My longer-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

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