“The market is a no-called-strike game. You don’t have to swing at everything – you can wait for your pitch. The problem […] is that your fans keep yelling “Swing, you bum!” – Warren Buffett
There are many quotes from market wizards that talk about “patience” and “choosing your spots”. Buffett does more by saying “your fans keep telling you to swing“. It’s very true that all professional money managers & traders suffer from the same issue:
- retail traders often “look for action”
- retail traders often “feel” they aren’t doing a proper job if they are not in the market
- retail traders are often “too close” to the markets to realize they are in fact overtrading
The “internal voices” that force retail traders to seek activity are not too distant from the “external voices” that give money managers a hard time:
- clients seeking constant profitability
- clients asking questions about lack of activity
Unfortunately, patience and being able to sit on hands are two qualities that retail traders need to possess. I cannot highlight this fact enough. In the attempt to “seek action”, I have witnessed many traders erode their accounts. What I’d like to convey, in this article, is that by measuring volatility consistently, retail traders have way to know (approximately) when it’s better to be conservative and when to swing for the fences.
“If most traders would learn to sit on their hands 50% of the time, they would make a lot more money” – Bill Lipschutz, Market Wizard
In the chart above there is a real equity curve (in dark blue) and drawdown (pink) of a retail trader over the course of a few years. Notice how the upticks in volatility (as measured by the Deutsche Bank FX Volatility Index) are highly correlated with the upticks in profitability. Once again the message is clear:
- when volatility rises, it is easier to profit and traders can be more aggressive (for example, by pyramiding into positions)
- when volatility falls, traders need to sit on their hands more often and be more conservative (for example, by playing pullbacks or waiting for unequivocal market moving events to stir up some movement)
Try it on for size: below is the DB FX Volatility Index from Jan 1st 2017 to April 4th 2017. The only real uptick in volatility was from the last week of January through the middle of February. There were two odd weeks (the first and third of March) with a slight increase but both within a declining trend.
Why Volatility Matters
Directional volatility (which you can measure easily with ATR), simply means “things are moving”, which allows you to choose when to enter the trade. You can be less conservative, and less selective. Instead, when things are quiet there is usually no evident trend. Entries must be well selected and you have to get on the trend early when it does initiate.
But markets just don’t “decide” to become volatile. Remember that markets represent the coming together of countless agendas. What makes people react in the markets has nothing to do with indicators or magic lines: it’s all about sentiment.
Basically the markets are constantly absorbing and digesting the constant flow of market movers that we all see on our macro calendars each week. But not all events have the same weight. Volatility rises with events that have the capability to change or challenge current market sentiment (the assumptions the market has made as to what will maintain status quo).
And that is why it is essential to remain in touch with the influences that are driving the market each day and each week.
Over to You
Are you throwing darts at charts, blindly applying technical analysis or price action, wondering why some entries seem to work like magic while others just fall flat on their face? One tool that you may want to incorporate into your toolbox is a measure of volatility (pick one and stick with it).
Declining volatility will make your trading more challenging. Rising volatility will make your trading easier. Learn to sit on your hands when volatility is declining; learn to cast a wide net when volatility is increasing. Don’t treat each day or each week as if they were all the same. Learn to evaluate general market conditions, and learn to play the game like a pro.
About the Author
Justin Paolini is a Forex trader and member of the team at www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.