Abnormal Tape

One of the strengths of human nature is its ability to quickly adapt to changing environmental conditions. At its core this is the primary reason why human beings, a physically rather underwhelming species, managed to achieve dominion of all reaches of the planet we inhabit. Whether or not that is a good thing I leave open to debate. At the same time this purported strength can also turn into a weakness in that we are often quick to lose sight of what once considered a normal baseline.

I have often made the point that the emotional aspects of our human psyche are are completely unprepared for achieving success in the financial markets. A big part of that is recognizing context outside of recency bias – a cognitive inclination we all seem to share. For instance, if your system starts losing after months or even years of working fine – do you discard the system altogether, do you take a break from it, or do you simply keep trading through the rough patch?

Novice traders would probably take a handful of losses and then walk away. The worst approach in my not so humble opinion. More advanced traders probably split into the two remaining camps. I for one would most likely consider reducing position sizing for a while until I see concrete evidence that market conditions once again favor the particular system employed. Others would simply trade through it and quite frankly there is justification in doing that as most of my statistical analysis reflects that it produces superior outcome in the end. Nevertheless I personally feel uncomfortable with losses above 20R with a time frame of less than three months. So therefore I chose the former path, knowing that it lowers standard deviation in my SQN.

One of the big learning experiences over the years, and one I am quite regularly reminded of in my ongoing system development efforts, is that market conditions change on a constant basis. On an hourly basis every single system goes through a ongoing cycle of volatility. Some of that is clearly attributable to market hours and participation and being privy of it offers advantages in when to take positions, when to take exits, and when to wait for sideways tape to subside. On the daily charts things also cycle but it’s a lot less regular – you may see years with rarely any increase in volatility, except for the occasional obligatory correction.

The chart of the E-Mini above shows what I would call a pretty normal transition from a minor correction into an advance, after which we see a more thorough but pretty textbook intermediate correction. What follows is a strong reversal which  after a few weeks starts petering out but continues higher. The blue outlines highlight all the candles I would consider beyond two standard deviations during their respective period. It’s quite normal to see volatility explode higher during corrections which is a major seductive element of why bears are so eager to find red candles.

And here is the current view of the spoos in comparison. I actually should have done the reverse – highlighted all the candles which do not exceed what would have be considered two standard deviations over the past few years. Mathematically speaking the smaller ones are now becoming the outliers. And that tells us a lot about the market conditions we are operating in right now. We see in increase in gaps and fast reversals followed by even faster drops. And that chart does not even tell the whole story – for that we would have to post a series of intra-session charts, as the big moves happen mostly overnight when most U.S. equities market participants are locked out of managing their positions.

Which is why I’m rather surprised anyone is actually still active in this tape. Unless you are extremely skilled in playing the swings and suffer from chronic sleeping disorders at the same time (or are a trading robot from the future like Skynard) then your odds of success in this tape are rather slim. If you have participated in a traditional fashion (i.e. taking intra-day positions and holding them) then odds have it you’ve made several trips to the woodshed in the past six months or so. There are only two ways to approach high volatility sideways tape. And that is to either participate on a very short term basis – meaning playing the swings and taking profits before the bell. Or slow down your activities to a weekly and monthly scope and avoid all the intra-day noise. Of course the implications of doing that is taking entries at price extremes or major inflection points. Which sounds a lot easier than it truly is.

What I do keep emphasizing here is that this is not the same market we’ve been trading over the past few years. Yes, quantitative easing is still a major driver of investor confidence but one quick glance at the chart above would suggest that it is increasingly losing its effectiveness. Clearly the goal of the Fed and the ECB is that of market stability and they have both proven on numerous occasions that they will go to any length imaginable to stave off a major market correction, which is seen as politically untenable. Or at least that’s the popular argument and you may suspect that the truth is a bit more intricate – albeit outside the scope of this post.

It is quite possible that in a year from now we will look at this chart and scratch our heads wondering how we could have not see that the market was about to fall off the plate. Or nothing could happen and we just kind of continue higher, one quick headline fueled push after the other. I really don’t know – because if I was certain then I would be either buying a bunch of puts here or grab a truck load of long positions and be done with it.

But what I do know is that the bull market of the past five years most likely will not return. Central banks may succeed in propping up equity markets for another year or so but volatility is increasing rapidly and it must resolve at some point – one way or the other. My approach going forward will be to take stock of the situation near major inflection points and then assess my available options. I won’t be betting the farm but I am willing to employ a small portion of my assets toward a resolution.

I have two setups this morning but need to keep them for my intrepid subs:

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Cheers,