What I learned from two Market Wizards about volatility

Given that the markets have taken off to the downside so far in 2016, readers may be wondering why I have not taken any positions so far this year.

The latest version of the scans I use have incorporated some of the ‘visual characteristics’ I look for into the scan code. Prior to doing this I could probably eliminate at least 80% of the charts that came up as those visual criteria were not met. This means I now have far fewer charts to go through – further leveraging my time. If a setup doesn’t meet my criteria, then it won’t get traded. This is designed to keep myself out of what may be classed as ‘sub-optimal’ trades.

Now, my criteria are quite stringent, but they are based and refined on the characteristics of my previous big winning trades, plus other major trends that I have seen. This remains an ongoing process.

Part of the scan criteria now includes interpreting both the volatility factor indicator and the 2ATR measurement.

As mentioned in previous posts, I look to identify a contraction in these readings prior to an entry, with hopefully an expansion of those readings after entry (look here for more).

This idea I got from a couple of trading legends, who talked about this in their Market Wizards interviews:

The basic premise of the system is that markets move sharply when they move. If there is a sudden range expansion in a market that has been trading narrowly, human nature is to try and fade that price move. When you get a range expansion, the market is sending you a very loud, clear signal that the market is getting ready to move in the direction of that expansion." - Paul Tudor Jones

"The fourth thing Mint does to manage risk is track volatility. When the volatility of a market becomes so great that it adversely skews the expected risk/return ratio, we will stop trading that market." - Larry Hite

In other words, for me to take a position not only does does the 'structure' of the price chart need to be correct, but there also needs to be a contraction in volatility prior to entry. It is this element not being met that means I am getting so few signals at the moment.

This may differ from the ‘pure’ trend following method such as those traded by Richard Dennis and the Turtles, who seemingly took entry signals when price reached a particular level almost regardless of the current level of volatility in that instrument.

Again, to quote Larry Hite “I see risks, rewards and money”.

This is partly how I have refined my own trading methods over the years. While the basic concept is that of trend following, I have refined my rules to add in additional filters or elements such as looking at volatility. As such they have become a major cornerstone of my overall approach to the markets.

As it is, the current volatility levels are keeping me safe in cash until I start to see opportunities where the risk:reward profile is more appealing.