April 1, 2018
To say that volatility has picked up in the U.S. stock market this year would be an understatement. By one of the simplest measures, Average True Range (ATR), which measures the daily trading range, from high to low, has tripled in the S&P 500 from near $15 on January 1, to currently over $45. After a +7% move to start the year, SPY had an 11% pullback test down to the 200 day moving average, it’s first test of that level since November 2016. This was followed by a 10% bounce into March, followed by another 7% pullback over two weeks, down to test the 200 day moving average again. This sudden rise in volatility has been a sharp contrast to the record low volatility uptrend of 2017.
My firm belief is that a trader should always be operating under some form of written trading plan, which addresses risk exposure, markets traded, entry/exit signals and other aspects of trade and account management. Having a properly structured account helps to avoid the randomness of having no structure or process. Here are five key ideas that I follow and have been discussing with Members of my website to help navigate more volatile markets.
1. Consider Increasing Cash Allocations or Reducing Exposure
Many systematic, rules based traders, use volatility based position sizing, which simply means, the more volatile a position is, the less money it will have allocated to it, and vice versa. This is one proven method to help reduce exposure in periods of higher volatility.
From an account structure perspective, another method that I use is to raise my cash allocation and have less overall money at risk. In 2017, I averaged a 5% cash weighting throughout the year. In 2018, I have been as high as 60% for a brief period, and average cash has been between 15% and 40%.
The higher cash balance reduces my exposure, which will help reduce drawdown as well. It may also cap upside for the time being, but that is a trade off that I am comfortable with. By having less exposure, the decision is this: Less exposure = make less/lose less, or more exposure = make more/lose more. When volatility rises, or the primary trend is in question, I focus on less exposure. It is simple enough to add exposure at any time.
2. Consider More Active, Tactical Management for a Percentage of Assets
More volatile markets, and/ or trading ranges do lend themselves to more active money management, i.e. shorter term trading methods, to possibly increase risk adjusted returns or reduce exposure at any time. I accomplish this by using ETFs and essentially adding an index ETF, usually QQQ or another ETF, to put money to work when I get a shorter term buy signal, and scale out or exit the position when I get a shorter term sell signal. I have often held winning positions for over a year, based on market conditions. For my “shorter term” approach, the holding period may be only a few weeks. I will use one or two ETFs for this approach, and generally allocate up to 20% of assets to this method. By using a more tactical approach, it allows me to increase my cash allocation/reduce my exposure markedly at any time, without having to unwind multiple positions and also add incremental gains in what may be a longer term choppy/trendless market.
3. Do Less and Trade Less
Earlier in my trading career, I felt the need to always be “doing something”. Short term, long term, long side or short side of the market, often on both sides of the market at the same time. In any market, this can lead to increased losses, because every position is both an opportunity to make money, and also an opportunity to lose money. In more volatile markets, this can be a very dangerous strategy.
Over time, I have learned to not “play every hand” and to only play the best hands. Often this means, doing nothing. Not buying, not selling, just sitting in open positions, letting stop losses serve their role and let the market sort itself out until a better signal is given.
“Doing less” has been one of the single biggest improvements to my trading results and often takes time and concerted effort to implement. Take the best signal or setup on your screen and if there aren’t any “best” options, then don’t press the issue and take a trade just to do something.
4. Follow The Money and Look For Lower Volatility Trends Elsewhere
When the general stock market, SPY, or leading stocks get more volatile or start to trade in wider ranges, it is a good idea to look for lower volatility stocks and/or ETFs in uptrends, maybe off the radar screen of the standard mega cap stocks that dominate the indices. I run a number of quantitative data screeners daily that help me find uptrends, either in other markets or sectors. They may be based off price performance, new highs, or moving average signals. These often make for a good risk adjusted option, and if there are no uptrends, I wait.
5. Be Careful With Short Positions
This point goes back to Idea #3. I have been very vocal over the years, as have many professional money managers and traders, in cautioning about short selling, or being very careful with it. Industry statistics show that most retail traders lose money over time, and the short side is more difficult even for professional traders for a number of reasons. Downtrends trade differently than uptrends, can be more volatile and especially in single stocks, the gap risk can be huge. Many look to short a position after it has already made it short term down move and wind up shorting the low and get reversed out quickly. Many are shorting at the time they should be buying and then forced to cover at what often is the shorter term top.
Some try to “hedge” by being short and just add more risk and complication to the account. For most other than very experienced professionals. more positions usually equals more risk. By shorting individual stocks, there is also technically unlimited risk if the stock gaps sharply for any reason. If one feels the need to short, ETFs and/or put options may offer better risk adjusted returns without the single stock risk. Also, one well placed short position may be a much better alternative than trying to “short everything” and being reversed the other way. I learned this the hard way in 2008 when I was short a variety of bank, tech and metals stocks, and they all reversed at the same time. Less would absolutely have been more in that scenario, and I believe it still is.
These are a few key ideas from a bigger picture, account management point of view. Planning, structure and process often make the day to day management of positions more profitable, more consistent and less emotional. We focus on this type of planning daily on our website.