Volatility became a defining feature of the 2009 market
It is common at this time of the year for analysts to take a guess at what will happen in the next year.
We have some general ideas, but as with every year, the objective is to remain flexible enough to effectively trade the market as the situation develops.
We think it is more important to look at what has happened in the past year because there have been very important changes to the structure and operation of the market and these effect the way we trade in 2010.
The most important change is the increase in trend volatility. In 2009 we have seen strong up trends interrupted by periods of consolidation where multiple trend exit signals have been generated. Then, in many cases, the up trend continues strongly.
In other cases, the consolidation is followed by a rapid fall in price and the development of a new downtrend. The key problem is that the classical technical analysis methods have not been particularly successful at distinguishing between those stocks which will break upwards from the consolidation and those that will break downwards.
These up and down moves have also show a substantial increase in volatility. Index moves of 2% or more are now accepted as common. Prior to 2008 such large moves were unusual.
The VIX index which is a measure of US market volatility has declined, but this decline does not capture to full story. The market is dominated by erratic volatility that triggers stops. Traders cannot afford to ignore the stops in the hope that this is a false exit.
The confusion in the management of trends comes because traders are using an old definition of trend behaviour. From around 1937 to 2007 it was correct to assume that trend volatility was the same as price volatility.
If we measured price volatility then we automatically measured trend volatility. The chart shows the way these worked, and the problems that have been revealed with this understanding.
Many technical indicators, starting with the simple trend line, and advantaging to include more complex price volatility calculations using Average True range and other indicators all assume that price volatility is the best way to define the trend.
Broadly speaking in past years and decades this has been a good assumption. The chart shows how this assumption is no longer true.
Trends defined with price volatility have given multiple exit signals, but after a short correction, the up trend continues. This is not an unusual event in the 2009 market. It became a defining feature of the 2009 market and will continue to be the defining feature of markets in 2010 and beyond.
The trend correction was also often triggered by a substantial change in price volatility. These price behaviours developed even though the underlying trend behaviour remained bullish.
The change in price volatility is driven, we think, by an increase in the activity of derivative trading. This includes the activity of CFD providers who are required to hedge positions in the physical market.
By some estimates this now accounts for 40% of exchange daily turnover. This increase in derivate trading also includes the activity of Exchange Traded Funds.
This will be further increased by the activity of off-market liquidity providers, or ‘Dark Pools” when they begin to operate in the Australian market probably in late 2010.
The solution to working with increased volatility is to understand the difference between price volatility and trend volatility.
We use the trend volatility line (TVL) plotted using the Guppy Multiple Moving Average to understand trend volatility. This has been a very successful way of managing the trade after the trend is entered.
It provides a better definition of the trend and avoids the false exit signals generated by indicators that are based on price volatility.
The TVL line uses the amplitude of the trend to define the trend. It uses changes in the amplitude of the trend to determine the appropriate stop loss level, and the appropriate duration of the stop loss at that level.
Daryl
Guppy, well-known international financial technical analysis expert. He
is an equity and derivatives trader and author of books including Share
Trading, Trend Trading and The 36 Strategies of The Chinese For Financial
Traders. His weekly
analysis newsletters are followed in Asia and Australia.
