Volatility is Back

by Michael R. Bryant

For most of this year, it seemed like market volatility was a thing of the past. Lack of interest in the markets was reflected in a VIX reading consistently below 20. How quickly things change! Since early August, the volatility index has been above 30, with periodic readings above 40. While long-term investors may be cringing at the recent up-tick in volatility, it's a potential boon to traders.

While some of the increase in volatility may be seasonal, much of it may be more fundamental: the downgrade of the US credit rating by S&P, the prolonged economic downturn, and the debt crisis in Europe. All of which means that the higher volatility may be here for a while.

If it turns out that the factors affecting volatility persist for some time, the markets may undergo (or may have already undergone) a fundamental change in how they trade, particularly on short-term time frames. Such a regime change can either make or break a trading system. As typically happens under such circumstances, after the end of the year, we'll probably be reading about the fortunate traders who found their strategies in sync with the new reality and made out-sized profits as a result.

Anyone who doesn't currently find themselves in that position has two choices. They can wait for conditions to return to "normal" and hope their trading strategies start performing again, or they can start looking for new strategies that perform better under the current conditions.

My preference is for the latter, which seems more in line with the trading dictum "cut your losses short." Rather than "stay and pray", I'd rather move on to something that takes advantage of current conditions. Moreover, once markets undergo a fundamental change -- and who really knows if that's what's happening now -- they rarely seem to return to their prior form.

If you're considering developing a new strategy, it might be wise to keep in mind that the majority of trading volume is now attributed to automated trading strategies, such as program trading and high frequency trading. In other words, most trades take place between computer programs. This trend was one of the reasons I shifted my own trading strategy work from manual methods of strategy development to genetic programming (GP). The GP approach seems more in tune with the proliferation of algorithmic and automated trading strategies and may be more likely to find strategy logic that exploits the increasingly elusive and ever more complex inefficiencies in the markets.

Whatever your approach to the recent increase in volatility, change always offers opportunity, and this time is likely no different.
 

Mike Bryant

Adaptrade Software

*This article appeared in the September 2011 issue of the Adaptrade Software newsletter.

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