Bear Markets Are Hard
Bear markets in particular have a way of wearing on you. Sure they look great in hindsight, leaving little doubt about how you one could have easily banked millions. And quite frankly there is actually some truth in that (we’ll cover that later), but in reality most traders usually get chopped to pieces trying to time the endless preceding gyrations, only then to watch the tape run away without them.
In my time running this blog I have gradually shifted away from posting long winded tutorials as people’s attention span seems to be inversely correlated with the amount of information they are being exposed to. So today let’s look at two very simple ways to assess a market’s noise factor. Because noise and lack of technical context are inherently the type of conditions you should expect in the early phases of a large market correction. Even more importantly the amount of noise present may actually be a key characteristic that differentiates the early stages of a long term bear market from a mere medium term correction as part of a bull market.
In bull markets corrections usually happen within a set of predictable parameters. There are support levels that are usually being observed – moves to the downside happen quickly and permit bullish participants to pick up long positions for a significant discount. Buyers move in quickly and reassert themselves which produces quick reversal spikes which discourage the bears and in particular put holders as vega gets crushed quickly.
Here’s a weekly chart of the VIX which is telling a compelling tale about the perception of implied volatility among market participants. It is important to differentiate between realized volatility (i.e. volatility that has happened) and implied volatility (IV) which is the anticipation of future volatility. Clearly if we just scraped 53, like in last August, then odds have it that future volatility will be a bit lower as markets never move in a straight line.
In any case, observe how volatility exploded in regular intervals and then slowly dissipated in the ensuing months. Also note that, starting in about 2013 we are literally able to watch the bears throw in the towel and give up for good. Why? Because IV spikes are curtailed to below the 23 mark, at the very peak we are below 18 in July of 2014.
And then in late 2014 something changes. Watch how volatility is becoming, well – more volatile and less obligatory again. We are no longer observing the casual ebb and flow of an unrelenting advance. Now the spikes appear to be less nochalant, in particular after the August 2015 correction. Most of 2015 had been a sideways chop from hell but IV had managed to once more descend to the 11 mark. Which was quickly followed by the biggest spike since 2009 which touched the 53 mark.
Since then we are observing a rising lower threshold and that is exactly what we should be keeping an eye on. Forget about the big spikes up – they disconcerting of course. But what really makes all the difference is the floor – if it is rising then that tells you about the most optimistic attitude of the average market participant.
More observations regarding volatility cycles below the fold:
Assessing (realized) volatility cycles has become one of my core activities in the past few years. This is not about observing and adjusting to realized price volatility – it’s about correlating price in relation to volatility cycles in anticipation of the type of market period that may lay ahead.
If you recall my post from a few weeks ago – the current downside correction seems to have drastically different characteristics than the one we observed last year. For one last August we dropped quickly, then pushed sideways for a few weeks as a huge volatility spike slowly dissipated. After one final retest we started trending higher and then failed to breach through the March 2015 equity highs.
Now however we are seeing a collective sell off that originates from a low volatility base and actually didn’t push through the upper 2.0 Bollinger until near the end. That suggests systemic selling without panic. It also suggests that there are neither dip buyers nor is there significant profit taking from a large number of bears. The bounce that is currently playing has been accompanied by rising volatility, which in conjunction with a lack of technical context makes a) getting positioned and b) riding a campaign to a minimum target extremely difficult. For good examples look no further than yesterday’s E-Mini and EUR/AUD campaigns. Both stopped out after resolving to over 1.5R.
What we should expect in the coming weeks is at best a gradual reduction in volatility after which we may see more directional tape. However it’s also possible that volatility explodes further if we suddenly drop and breach the 1800 mark. Which makes the prior scenario the more favorable as it affords us an opportunity to get exposed while IV is low (i.e. puts are cheaper) and taking entries from a higher base.
Right now right here it is very difficult to play the downside. Puts are expensive and technical context is almost non-existent as we haven’t been producing any meaningful corrections tape for years. History tells me that you almost always get at least one more jump higher, however that is never guaranteed. As a matter of fact – if we drop hard from right here then we should be very concerned as it may represent only the first leg in a much larger secular bear market. I still think that we may just be dealing with a one or two year correction here. But a truly secular bear market can span a decade.
Alright, setups. I’m waiting for an entry on soybean oil near 30.8. Most likely I won’t get it as this things seems to be ready to take off.
NG – here I would like to grab a small position near 2.093 – you can see that diagonal I drew on the hourly panel, which is technically debatable. This could easily resolve to the downside of course. However that jump off the low son the daily suggests that this market many be ready to burn the shorts. As I don’t have a crystal ball (still in the shop) I simply trade what’s in front of me – and that right now is the possibility of a short term bounce. Small position sizing on this one by the way – there’s a reason we call it the widow maker 😉
I am going to grab some belated lunch and then hunt for a few more setups. If I do find anything delectable I’ll tack it on below.