.When you set your profit target by finding a resistance level on a chart,the volatility of prices tells you where to look. Don’t pick a minor resistancelevel that’s $1 above the current price when the market volatility is $2 a day,and don’t expect a profit of $10 when prices only range $0.50 each day.
Changing Your Stops to Reflect VolatilityThe same principle applies to stop-loss orders. If the stop is inside the normaldaily trading range of AOL, then you can be sure that you’ll be stopped out.How far away should you place your stop? Look for a support level at about3 times the volatility below where you enter your long trade and place yourstop-loss on either side of that level—depending on whether you are lookingfor free exposure or confirmation.If you’re a technical trader and you are not using charts, then you can setyour profit target and stop based entirely on volatility. If you have justentered a long position in AOL at $15 and the stock has been trading in a $1daily range, then:Profit target = entry price + (profit factor × daily range)= 15 + (2 × 1)= 17
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Stop-loss = entry price − (stop factor × daily range)= 15 − (3 × 1)= 12You’ll note that the profit target is 2 times the volatility and the stop is3 times the volatility. The profit target is closer than the stop-loss. Thisis the normal pattern when you’re a short-term trader. You want to be sureyou capture profits as often as possible. To do that, you’ll need to take alarger risk on each trade. If you make your stop closer than your profit target,then you’re sure to be stopped out more often and end up as a loser. Thecloser order is most likely to be hit.
VOLATILITY EXTREMESWe have seen in previous chapters that if there is extremely high volatility orextremely high volume, then a price reversal follows soon after—prices cannot keep going the same direction on increasing volatility.The problem with knowing that prices will reverse and being able totrade that pattern successfully is the risk. High volatility is high risk, and theonly way to offset that risk is by trading a much smaller position. In somemarkets, such as the 1987 stock market crash, the potential profits weren’tworth the risk. Even in less extreme markets you may feel that the risk is justtoo great. That’s called common sense. First look at the risk and then thereward. If you are in doubt, don’t trade.
Principles of VolatilityTwo important principles of volatility are:1. High volatility is associated with high risk.2. Low volatility is associated with lack of direction.
Although we know that high volatility is intuitively risky, we might forget the risk of low volatility. Low volatility occurs when there is low participation in the market. Investors don’t expect anything important to happen,and short-term traders disappear because they need the volatility to be profitable. These are the signs of a stock that’s going nowhere. The public voteswith its money. No one is voting.
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A High-Volatility SystemA system that was once very popular is a good example of how volatilitycan be used to trade. It has (or had) good reliability but high risk. It profits from a continuation of a volatile day that shows clear direction. You canfind examples in Figure 17.4:1. Buy a high-volatility day if prices close in the upper 90 percent of the
range.2. Sell a high-volatility day if prices close in the lower 10 percent of the
range.3. Close out the trade shortly after the open of the next day.4. Do not enter the trade on Friday.
How big is a high-volatility day? You could set an absolute value of $3 for astock trading at $20, or $10 for a stock trading at $100, but you’ll do best withsomething that adapts to changes in volatility.If you take the average volatility, for example, the average of the 65-daytrue range, you get the typical volatility over the past calendar quarter. If
FIGURE 17.4
Find examples of trading high volatility. When prices get volatile, you canbuy if the close is near the high or low and liquidate the trade on the next open.
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today’s true range (the range including the previous close) is more thantwice the average, then we have a high-volatility day. The average true rangeallows the volatility to change over time. We don’t need to rethink normalvolatility every few weeks. Remember that trading during high volatility isalways risky.
VOLATILITY AND YOUR PORTFOLIOThe volatility of each stock in your portfolio measures the risk of that stock.All things being equal, high-priced stocks have greater volatility than lowpriced stocks. To give ourselves the best chance of profits when we’re trading more than one stock or futures contract, we want to equalize the risk ofour positions. In that way we improve diversification and minimize risk. It’sall about controlling the risk.Institutional money managers use portfolio optimization to balancethe assets for clients. This is done with a mean-variance solution, such asquadratic programming, typical of Modern Portfolio Theory. The portfoliooptimizer balances the volatility and cross-correlations of each componentand calculates the weights that give you the best return-to-risk ratio.
Correlations and DiversificationCreating a formal portfolio is a process that is too complicated for our purposes. We do need to realize that trading two bank stocks does not give youthe diversification of trading one bank stock and a pharmaceutical company,or Intel and pork bellies.Don’t forget that real diversification reduces risk and gives you a betterchance of being successful. Trading in two different stocks or futures markets is much safer than trading in only one. Trading in three or four is evenbetter. More than four begins to be less important.
It’s Not the Markets, It’s the MoneyOn most days you can get diversification from trading stocks in unrelatedsectors or industrial groups. News will affect these groups differently. Energymay be strong on concerns about instability in the Mideast, while health careis weaker because of pending political legislation that limits reimbursement.However, in a crisis, such as 9/11, all markets move together. It’s not thefundamentals or the value of the stock, it’s the people who own the shares
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who decide to get out. Money seeks a safer place. Stocks drop on widespreadselling and bonds rise on widespread buying. No amount of correlation analysis or diversification will save you from a price shock in which all marketsmove the same way.
Mistaking Luck for SkillDon’t be fooled by anyone who shows that they profited from a price shock.They were simply lucky. You can’t predict a price shock. You simply had awindfall profit or an unfortunate loss. Be grateful if it is a profit and get outof the position. The market is out of control.Major price shocks occur infrequently, but are fatal to many traders.Even the smartest minds are not immune. There are only two ways to minimize your losses:1. Don’t hold a position longer than necessary. Get into a trade when
you think that prices are going to move soon. Get out as soon as possible.You don’t want to be holding a position in any one stock more than 30percent of the time. Less is better.2. Try to make as much as possible by investing as little as possible. The
less you have exposed, the less you have at risk.When a price shock occurs, the ones who survive are those who had theleast exposure. By holding positions only 30 percent of the time, there is a70 percent chance you will be out of the market when a price shock occurs.In addition, if you have only a small position, then a loss will not be a disaster. The combination is as good it gets.You may trade for years before experiencing a major price shock, but history is clear. They occur every few years, they are violent, and they leavemany traders in ruin. Don’t be one of them.
BALANCING YOUR PORTFOLIOYou start by selecting stocks and/or futures markets that offer low correlation. You then measure the volatility of those items that you’re trading. Itmakes most sense to calculate the volatility over the same number of daysthat you expect to hold the trade. Therefore, if your typical holding period is10 days, then calculate the average true range of that stock over the most
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recent 10 days. You will find it easier to calculate the volatility for each stockon a spreadsheet.
Method 1: Trading an Equal Number of SharesOne of the easiest ways to trade is simply to buy or sell an equal number ofshares in each stock. It is also the worst way. When you trade an equal number of shares, those stocks with higher volatility or higher price will overwhelm everything else.Example 1Company ABC trades at $100 and has average daily volatility of $5.00. Company XYZ trades at $10 and has an average daily volatility of $0.50. If you buy100 shares of each stock you will risk:1. $5.00 × 100 = $500 per day in ABC.2. $0.50 × 100 = $50 in XYZ.
If each stock moves the same percentage, then the returns of ABC will be 10times the returns of XYZ. Your success rides entirely on the results of ABC.Can you correct this by buying equal dollar amounts of ABC and XYZ?
Method 2: Trading Equal Dollar AmountsThe most popular advice is to trade equal dollar amounts of each stock. Onthe surface, this solves many of the problems. Let’s assume you have $1,000in investment capital.Example 2We will continue to use the high-priced ABC and the low-priced XYZ. We buy$500 worth of ABC trading at $100, or 5 shares. We buy $500 worth of XYZtrading at $10, or 50 shares. On a typical day, ABC gains $5.00 and XYZ loses$0.50. In dollars, ABC gains $5.00 × 5 shares = $25. XYZ loses $0.50 × 50shares = $25. When stocks move in opposite directions and the profits andlosses exactly offset one another, you have a perfect hedge.The purpose of diversification is to profit from everything in your portfolio when you’re right, and to lose as little as possible when you’re wrong.When the volatility of stocks is directly proportional to their price, thenbuying equal dollar amounts works well. This is the ideal price-volatility
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relationship, and may be reasonable for long-term analysis. However, neitherlife nor the market is perfect.It Sounds Good, but It Doesn’t Work. Trading equal dollar amountsworks in theory but not in practice. Not all stocks have the same volatility atthe same price. Some stocks are simply more volatile than others. A high-techcompany trading on the Nasdaq at a low price typically will be much morevolatile than a public utility trading on the New York Stock Exchange at ahigh price. Intel at $16 is one and a half times as volatile as Cinergy at $32.Example 3: An Actual Volatility Relationship with Equal Dollar AllocationWe have both Gold Fields (GOLD) and Merck (MRK) in our portfolio. MRKis trading at a higher price and has greater volatility than GOLD, but they arenot in the classic percentage relationship. GOLD is trading at $10 with average daily volatility of $0.50, and MRK is trading at about $55 with averagedaily volatility of $1.00. We still have $1,000 to trade. If we trade equal dollaramounts, then we buy $500 worth of GOLD, or 50 shares, and buy $500 worthof MRK, or 9 shares.On a typical day Gold loses 50 × $0.50 = $25 and MRK gains 9 × $1.00,or $9. You have a net loss of $16. This happens because the volatility is notin proportion to the price of the stock.The mistake is that the long-term volatility relationship doesn’t reflectwhat’s happening in the market now. We don’t care about the average 10-yearvolatility when we’re holding the trade for the next five days. Your risk is relatedto the holding period of your trade, not to the long-term analysis of the market.
Method 3: Allocation by VolatilityLet’s look again at two different stocks, a large, stable company BIG, tradingon the NYSE, and a new, hi-tech company NEW, trading on the Nasdaq. NEWis more volatile than BIG relative to its price. BIG trades at $100 and has anaverage daily volatility of $3.00 (3 percent), and NEW trades at $25 and has anaverage daily volatility of $1.00 (4 percent). How many shares of BIG andNEW do you buy so that your total risk is equal? We’ll need to do some arithmetic to get the answer.Finding the Allocations Based on Volatility. For an investment of $10,000we want to buy B shares of BIG and N shares of NEW. We know that:1. The sum of the share prices times the units (B and N) is equal to the
investment; therefore:
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10,000 = (100 × B) + (25 × N )2. The volatilities should be equalized by the number of shares; therefore:
B × 3.00 = N × 1.00We can find the values of B and N by first solving Equation (2) for N = 3 × Band substitute that answer into Equation (1). Equation (1) becomes:10,000 = (100 × B) + (25 × 3 × B)10,000 = (100 × B) + (75 × B)10,000 = 175 × BB = 57Substituting B = 57 back into Equation (2) and solving for N, we get N = 171.On a typical day we may have BIG drop $3.00 × 57 shares = $171 loss,while NEW rises $1 × 171 = $171 gain. The net is zero and the portfolio is perfectly balanced. Note that 171 × 25 + 57 × 100 = $9,975, which leaves room totrade another share of NEW. However, that would put the volatility ratio outof balance, and you wouldn’t have balanced risk when something goes wrong.Calculating Volatility for a Larger Number of Stocks. If you are tradinga larger number of stocks, then solving all these equations will get tedious.Instead, you can use a spreadsheet to create a volatility table. The trick tousing the volatility table is to arbitrarily pick a target volatility that is bigenough to assign shares to each stock. A large target volatility will mean thatyou would have a large investment, which isn’t true, but we’ll fix that at theend of the calculation.The target volatility is the amount of risk you will take each day foreach stock. In the following example the target volatility is $5,000 per day. Ifthe stock has a daily trading range of $1, then we would trade 5,000 sharesof that stock.Based on a daily target volatility of $5,000, the following table shows howmany shares we would trade and how much of an investment it would taketo trade that position:
Stock AStock BStock CStock D
Current Price
Volatility
Shares Neededat Volatility of$5,000/Day
$30$10$100$50
$0.75$0.50$1.00$1.00
6,66710,0005,0005,000
Capital
$200,010$100,000$500,000$250,000
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Therefore, if we traded the four stocks, A, B, C, and D, each with a dailyrisk of $5,000, we would trade 6,667 shares of A, 10,000 shares of B, 5,000shares of C, and 5,000 shares of D, for a total investment of $1,050,010.Of course, we don’t want a daily risk of $5,000 and we don’t have a million dollars to invest, but we can scale this to any investment level. If we arewilling to take a risk of $500 each day in each market, then we can theninvest one-tenth of the amount, $105,001, and trade one-tenth of the numberof shares in each stock. We can divide that by 10 again and invest only$10,500 by trading 66, 100, 50, and 50 shares of stocks A, B, C, and D. It’s abackwards way of solving the problem, but it’s easy.When you create a portfolio you start with the question, “How much amI willing to risk?” From there you find out how much you need to invest, andthen you decide how much profit you can expect. You always start with therisk. If you can’t get enough profit for the risk you are taking, then don’t trade.
ADDING FUTURES TO THE PORTFOLIOAND ADJUSTING FOR VOLATILITYUsing volatility makes it easy to include futures and stocks in the same portfolio, although the calculation may be a little more complicated. Let’s saywe have a $100,000 investment with the high-priced stock ABC and the lowpriced stock XYZ as before. Company ABC trades at $100 and has an average daily volatility of $3.00. Company XYZ trades at $25 and has an averagedaily volatility of $1.00.We want to add a futures contract in crude oil (CRUDE). CRUDE is trading at $25 and has volatility of $1.50 per day.We know that one contract of crude oil futures is an obligation to trade1,000 barrels of oil; therefore, a $1 move in the oil price, from $25.00 to$26.00, will net a profit or loss of $1,000. If crude has a volatility of $1,500 perday, that translates into a risk of $1,500 per day ($1.50 volatility × $1000 per$1 move = $1,500 risk) while a single share of ABC at $3.00 per day is $3.00and a single share of XYZ is $1.00 per day of volatility.
Equalizing the Risk of Futures and StocksThe next step is to equalize the risk of the futures contract and stocks in thesame $100,000 portfolio. We want equal volatility; therefore, if ABC, XYZ,and CRUDE are the units to be traded (ABC and XYZ in shares and CRUDEin contracts), then each stock or futures contract has risk equal to:Risk = share price (or futures price) × daily volatility × number of units
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If the risk is to be equal, then:Risk(ABC) = Risk(XYZ) = Risk(CRUDE)ABC(× 1) × 3.00 = XYZ (× 1) × 1.00 = CRUDE × 1000 × 1.50
(1)
We also know that the total capital (if fully committed) should be:$100,000 = ABC × $100 + XYZ × $25 + CRUDE × $3000
(2)
Note that the margin of $3,000 is used for futures instead of the share price.We start the solution by solving one pair of equations:ABC(× 1) × 3.00 = CRUDE × 1000 × 1.50CRUDE = 3 × ABC / 1500We then solve the next pair of equations:ABC(× 1) × 3.00 = XYZ (× 1) × 1.00XYZ = 3 × ABCSubstituting ABC for XYZ and CRUDE:100,000 = (ABC × 100) + (3 × ABC × 25) + (3 × ABC / 1500) × 3000100,000 = (100 × ABC) + (75 × ABC) + (6 × ABC) = 181 × ABCABC = 552.5 (rounded down to 552)ThenXYZ = ABC × 3.00 = 552.5 × 3.00XYZ = 1657CRUDE × 1500 = XYZ = 1657CRUDE = 1.10Verifying the results, we see that the daily dollar volatilities are nearly equalfor the two stocks and as close as possible for the futures contract:ABC × $3.00 × 552 shares = $1,656XYZ × $1.00 × 1657 shares = $1,657CRUDE × $1.50 × 1000 conversion = $1,500 (due to rounding)The capital used isABC = 552 × $100XYZ = 1657 × $25CRUDE = 1 × $3,000TOTAL = $99,625
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ACCOUNTING FOR THE CORRELATIONSA proper trading portfolio allocation considers both volatility and correlation. That is, you want to trade more of those stocks that have the least similarity to one another. The combination of equalizing risk (volatility) anddiversifying among noncorrelated markets results in a portfolio that maximizes returns with respect to risk. However, that is only true in a passive(buy-and-hold) portfolio.When trading, we should be looking at the correlation in daily returns,not prices. For example, if we are long the S&P and prices drop 1 percentthen the return is a loss of 1 percent. Because the price of the S&P droppedat the same time, the daily return and the price are correlated.If we are short when the S&P drops 1 percent then our return is a positive1 percent while the S&P price posts a 1 percent loss. It doesn’t matter if theS&P price went up at the same time bond prices went up. What does matteris whether we were profitable on both the S&P and the bonds.If we consistently return profits on the S&P and bonds on the same days,and then lose in both markets on the same day, we are 100 percent correlated. It doesn’t matter in which direction prices are moving.
Substituting PricesIf you’re just starting out and don’t have a history of trading performance,then you have no choice. You can only look at the correlation in prices. Wewill assume that if prices move in a similar way, we would have made similar trades.
Cross-CorrelationsWe can find the correlation in prices by downloading the price history froma website (e.g., MSN Money Central) or from most quote machines using theexport feature. From there you can load the prices into a single spreadsheetand use the function correl to create the cross-correlation Table 17.1. Eachcell gives the correlation of the stocks in the corresponding row and column.If we look at all of the cells in the cross-correlation table, we can see:• The highest correlation is 0.60 between SP500 and WMT.• The next highest is SP500 and MRK at 0.15.• There are four negative correlations.• There are four other lower correlations.
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Anything above 0.20 is considered moderately correlated. Any correlation factor over 0.50 is strongly correlated.
Big Money Moves the SameAlthough Wal-Mart may have been rising or falling during the past fewmonths, it moves in the same direction as most other large-cap stocks onmost days. That’s because traders can buy and sell the S&P futures contract,Spyders (SPY), S&P Mutual Funds, or other S&P index clones.When they buy or sell the index, the arbitrageurs (or program traders)enter to make sure the spread between the index and the actual stocks comprising the index does not get out of line. You can’t have the futures pricegoing up 10 full points while the actual stock prices don’t change. Therefore,whenever there is significant buying in the index, that buying also forces allthe stocks in the index higher, regardless of the individual personalities ofthose stocks.In the absence of news specific to a particular company, Big Moneytreats all stocks in a similar manner. It buys and sells baskets of stocks.
Negative CorrelationsWe should not assume that a negative correlation in stocks means that pricesactually move in the opposite direction. It is safest to consider it as uncorrelated; that is, some days it moves with the other markets and other days itdoesn’t. On extreme days, when you need the diversification the most, it issafest to expect all the markets to be correlated and move together.In Table 17.1, the negative correlations in Raytheon and Gold Fields werethe result of September 11. Traders immediately recognized that defensestocks would be the first to benefit, and cash gold prices rose because in-
TABLE 17.1
SP500WMTMRKGOLDRTN
Cross-correlation table. Four stocks, Wal-Mart, Merck, GoldFields, and Raytheon, are compared with the S&P 500. Exceptfor Wal-Mart and the S&P, the correlations are very low, showinggood diversification.SP500
WMT
MRK
GOLD
RTN
1.000.600.15−0.17−0.13
1.000.10−0.15−0.05
1.000.050.12
1.000.09
1.00
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vestors traditionally move money to hard currency, a safe haven in a crisis.Gold stocks benefit from the rise in gold prices. On normal days they maymove the same way as the bulk of stocks. Under a different economic scenario, such as an unexpected increase in interest rates, those stocks mayreact exactly the same as others in the S&P. You cannot count on them offering diversification all the time, but they can help out once in a while.
Adjusting Your Portfolio for CorrelationsIf the correlation between two markets is very strong, then treat it as onemarket when deciding how much to trade. If the average correlation in yourportfolio is above 0.20, then your only choice is to trade less of your capital,thereby reducing your risk exposure in the event of a price shock. When trading on your own, simply choose those stocks that are fundamentally different. It’s safer that way.
TRADING GAME TIPSYou don’t learn anything by making money. In case you’ve had a difficulttime with this trading game, take heart from the fact that losing moneyteaches you more than making money. If you made money by luck, then youdidn’t review your trades to find out what went wrong. Losing makes youevaluate your work carefully. In the end, you’ll have a better understanding.Do the analysis yourself. Long before we found out that market analystshad a conflict of interest, promoting those stocks in which their company hada financial interest, we should have known that you must analyze the marketyourself. You can’t make a trade unless you know why and understand therisk and reward. Don’t believe anyone. Even your friend, who bought something last week, will try to sell you on it. Don’t do it. Study the market andchoose your own trades.Be proactive. Some of you will miss a trade because you’re waiting to seehow it does tomorrow. You’re too late. You need to act today. Place the orderand put a stop at a safe place. You want to be in early to get the free exposurewhen prices jump. Anticipate, don’t react.Reversing your position. It often turns out that the trade you expect tobe the most profitable is the largest failure. When a clear signal fails, itbecomes likely that a large reversal will follow. Don’t be slow about reversing your own position. Don’t take the bad signal as a personal insult—takeit as an opportunity for a larger profit.
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Recheck the correlation between stocks in your portfolio. If the stocksare moving together too often and you have all profits and all losses on thesame days, then change some of the stocks that you’re trading. Stay on top ofyour portfolio.
Questions1. What is the best single word that describes a price shock?2. Give three ways that you can protect yourself from a price shock.3. What happens to the correlation between stocks, and even futures mar-
kets, when there is a major price shock? Why?4. We know that any one day can be more or less volatile then the next.
Under normal conditions, do prices get more volatile when they go up ordown? Specifically, what about IBM, the Euro, crude oil prices, and Treasury notes?5. To find the “true range” of the day, you need to find the largest of what
three values (using high, low, and closing prices)?6. As a short-term trader using profit targets and stop-loss orders, which
would be closer, the profit-target or the stop-loss order?7. What does low volatility imply with regard to price movement?8. If you are trading three stocks, A, B, and C, with corresponding daily
volatilities of $1, $2, and $3, what percentage of your total capital wouldyou place in each one to minimize risk?9. You are trading two stocks, A and B, and gold futures. Stock A has a daily
price range of $3, stock B has a daily range of $4, and gold has a dailyrange of $3/ounce. The gold contract is 100 troy ounces. How manyshares of A and B do you need to trade so that each stock has the samerisk as gold?
C H A P T E R 18
Dow TheoryThe more things changethe more they remain the same.
e’ve nearly come to the end of this course in technical trading. Westarted by studying charts and trends and looked at retracements,momentum, and overbought/oversold indicators. Finally, we studied how volatility can be used for trading, risk control, and balancing yourportfolio. However, Dow Theory, the most well-known of all technical methods,was conspicuously missing.Dow Theory is a grand plan. It tries to identify the big picture and offerbroad rules for deciding on the direction of prices. We have been very specific in these chapters, carefully measuring trendlines and breakouts, calculating profit levels, and looking for technical divergence. It seems to be theright time to decide if Dow Theory makes any sense after 100 years.
W
DOW THEORYCharles Dow determined that the stock market moved as the ocean, in threewaves, called primary, secondary, and daily fluctuations. The majoradvances and declines, lasting for extended periods, were compared to thetides. These tides were subject to secondary reactions called waves, and thewaves were comprised of ripples. In 1897 Dow published two sets of averages in the Wall Street Journal, the Industrials and the Railroads, in orderto advance his ideas. These are now the Dow Jones Industrial A