Risk And Reward – Volatility Trading Part 3
This third article in the series on Volatility & Trading will show you the incredible power of volatility tools in Technical Analysis. This session of study can revolutionise your trading results as you find out how to use these tools in your trading & investment decisions.
Please Note: This article assumes you have read and understood the first two articles. I strongly recommend you read again the previous articles to capitalise on your learning. Kirk Northington, CMT of ND Research, is one of the very best writers on this subject. He makes a complex subject easy to read, but it remains a complex subject. Read over this series a couple of times – let it thoroughly sink in.
My suggestion is to study these articles. Try the tools for 3 months and see what a difference they make to your approach to the markets. Send us any feedback you have, especially great results you are achieving. We love hearing from you!
Read Part 1 | The Sandpiper & Trading
Read Part 2 | Redefining Support & Resistance
Volatility and Trading : Risk and Reward
Let’s talk about danger. Do you think you are safe? Right now as you read this? How about the next time you eat out at a restaurant? Obviously it depends on all the things that can go wrong and their associated probabilities; food poisoning, choking on a bone, etc.
How safe are your exchange traded investments or current positions? Once again it can depend on all the things that can go wrong and their probabilities.
Obviously we are willing to take risks, otherwise we would not be trading, right? Do we really know how much we are risking?
We’re going to delve into this rather large question and relate it to some aspects of the ‘market microstructure’. We will then map that to opportunity – for making money of course.
So let’s carry forward the points of focus from my previous article. These concepts are important for quantifying current risk, future risk, and opportunity.
Honestly this can be a long, dry topic. Let’s cut through all that.
The market we see on publicly accessible exchanges consists of much more than is visible. An iceberg comparison would even be applicable here.
Market Microstructure: consists of all the components within that market that contribute to price discovery and value delivery. Current academic views are that these components are transaction costs, prices, quotes, volume, liquidity and trading behaviour.
Yes . . . my eyes are glazing over already too.
In trading we mostly concern ourselves with value determination – the pieces that affect a security’s traded price. This is an important distinction because most technicians believe that a security’s price tells all.
I’m not convinced of that. There are more dimensions. I’m not talking about space-time or anything like that. But it would be cool if that had some significance here . . .
I believe that the volatility of related financial instruments is also important. Especially when we can express volatility on the price scale.
Implied volatility (IV) is an important piece of the microstructure. Specifically, will IV increase or decrease over the coming days or weeks? That’s an important question. If it increases then the price and demand for a stock’s option could likely go up.
Why is this important? You’re likely asking this right about now. I’ll answer this question with two questions.
- Why does Volatility Based Support Resistance (VBSR) actually work?
- Why is it statistically viable?
Bear with me and you’ll see why.
I sought these answers. The hypothesis I couldn’t disprove amazed me, and still does.
VBSR has a cause and effect relationship with Implied Volatility.
When Implied Volatility is trending higher or lower, and a VBSR signal occurs, then Implied Volatility will likely cease trending and change directions.
Pretty wild right? If you’re the “oh yeah, show me proof” type of person (like me!), then take a look at the quantitative study results here.
In this study we isolated the top five stock positions in the nine Select Sector SPDRs. We aligned all VBSR signals with 30 day Implied volatility data, in these 45 large cap stocks, from 2004 to 2013.
The results showed us that VBSR signal conditions correlate directly with directional trend changes of Implied Volatility. The full details are in the above two page fact sheet.
Microstructure Advantage Example
Let’s see how we can turn this technical phenomenon into opportunity. I’m about to get wordy here, but precision is important.
Overview: Apple (AAPL), using VBSR, within a short-term risk / long-term reward analysis framework. The decision time is NYSE market close on July 8, 2015. Assume no information known past that time. Below is the best practice interpretation of the VBSR tools.
- The intraday chart shows us that the SR 7/8 support zone is between 121 and 122. This is our short-term risk. Going forward, if price closes below it for 3 bars or more than 3 ATRs, then consider support to be broken. This defines short-term risk.
- On the daily chart, price closes inside the lower N band support zone and triggers an N band support signal (N). The current SR 5/6 and 7/8 zones are overlapping, with price closing near the SR 5 line. This all tells us that price is now firmly at support. Based on the performance characteristics of VBSR, the directional movement of price – once it enters this support zone – should change from down to sideways or up over the next 3 to 5 bars. We can also see overhead that the upper N band resistance zone is at approximately 130 to 132. This defines the potential long-term reward.
- Implied volatility has been trending higher. The N band support signal (N) occurring at this point tells us (quantitatively) that 30 day Implied Volatility (IV) should cease trending higher, and likely begin to reverse or move sideways. Thus, if IV reverses then it means market participants believe that price will revert to its mean; short term reversal.
- The Risk Reward Ratio (RRR) tool on 7/8/2015 shows a reading of .5 Risk and 5.5 Reward. That’s a good ratio. This tool interprets current support and resistance levels separately, then calculates the quantity of Average True Range units (ATR-14) to those levels.
Aggregated View: These VBSR technical measurements give weight to a forecast of price trading sideways or reversing higher, for the 3 to 5 trading days going forward. The potential reward is quantified. The potential risk is quantified. These are important pieces of information required for proper trade management.
Below is the resulting price action for July 9th forward:
Note: this is an illustrative example and obviously all instances are not this clean and perfect.
Several possible ways to trade the above are outright long position, buy calls, or sell covered puts.
Note that momentum and trend should also be inputs to a good technical decision. But we’ll save that fun for articles in the near future.
Implied Volatility is undeniably a highly important element of the market’s microstructure. I think it’s the most important element along with price.
As we discussed in previous articles:
- Implied Volatility is the most heavily weighted input to derivatives valuation models.
- Big Money is structurally mandated to act (buy and sell) on risk models – and thus derivatives valuations.
- Directional movement (trending) of Implied Volatility determines supply and demand for derivatives – and thus the price of derivatives and the underlying securities.
Implied Volatility is not just a measurement. It’s a thing; a tangible part of the market. VBSR correlates to Implied Volatility directionality.
In our next article we will see a whole new method for identifying trends. I’ll reveal how VBSR can provide advantages in longer-term market directionality.
Read Part 4 | To Trend or Not to Trend
Do you think your brokerage account holdings (investments) are safe? Do you think market volatility will continue or worsen?
I think the safety of exchange-traded securities is getting less so every passing month; and I’m not the only one that thinks so. Why is this? Consider what follows.
In my book Volatility-Based Technical Analysis I cite the work of Richard Bookstaber in his book, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation.
Bookstaber’s thesis is that the financial industry continues to make more advanced and complex securities, and ways of interconnecting disparate parties. While it’s done in the name of efficiency and risk mitigation, the opposite effect is the outcome.
The question posed by this book, simply put, is: Why can’t the financial markets get their act together? Why are markets actually becoming more crisis-prone?
One answer can be found in the effects of innovation. It’s undeniable innovation has had some positive effects on the markets.
But the positive effects of innovation come at a price. Innovation increases complexity. Many innovative instruments are in the form of derivatives with conditional and nonlinear payoffs. When a market dislocation arises, it’s difficult to know how the prices of these instruments will react. Innovation and mechanical efficiency have also increased complexity by pushing markets to become more interconnected. Thanks to globalization, a problem in one market can affect another even when there is no economic relationship between the two, simply because investor portfolios or bank credit lines have exposures to each. Innovation has also led the markets to become tightly coupled. This tight coupling, and the resulting higher liquidity, makes it easier to take on levered positions, because more liquid and readily priced securities make for better collateral.
Here’s the amazing part. He published this in 2007; one year prior to the financial crisis of 2008. He was prophetic in his ability to identify how we are continually making financial markets more and more systemically risky. His work is a good read if you are interested in this topic.
Kirk Northington, CMT
Co-founder of Northington Dahlberg Research, LLC
Kirk is a co-founder of Northington Dahlberg Research, LLC and is a quantitative technical analyst. He is a member of the Market Technicians Association, and is a Chartered Market Technician. Kirk is a frequently requested speaker on the topic of volatility trading and volatility based market analysis.
He is the author of Volatility-Based Technical Analysis: Strategies for Trading the Invisible, Wiley Trading Series, John Wiley & Sons Publishers; in which he pioneered new concepts in technical and quantitative analysis. Kirk has a BS degree from Nicholls State University, in Thibodaux, Louisiana. He has extensive experience in institutional market risk, process control system design, and software engineering.