Janice Dorn, MD, PhD
Neuropsychological Trading Coach
Janice Dorn, M.D., Ph.D., has been a full-time futures trader since 1994. Doctor Janice holds an M.D. in psychiatry and is board-certified by the American Board of Psychiatry and Neurology in general psychiatry and addiction psychiatry. She holds a Ph.D. in brain anatomy. A graduate of Coach University, she is a pioneer market psychiatrist and financial neurobehaviorist. Doctor Janice has written over 500 articles on the financial markets and coached over 600 traders worldwide. She is the Global Risk Strategist for Ingenieux Wealth Management Group, Sydney, Australia.
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Upside down
Boy, you turn me
Inside out
And round and round
…from: "Upside Down" by Bernard Edwards and Nile Rogers, Sung by Diana Ross
Volatility is the tendency for prices to change in an unexpected manner. The two major reasons for this change are responses to some new information about value of a traded security (fundamental volatility) or responses to the demands of traders for liquidity (episodic volatility).
There are many ways to look at volatility, some highly mathematical and confounding. That said, options traders live and breathe by volatility, be it historic or implied. Stock and futures traders can either use it to their advantage or get blindsided by it.
Volatility changes with time—i.e., there are times when the markets are quiet and times when they are violent. Often, large price changes occur within very short periods of time, catching many people off guard or leaning the wrong way. This abrupt, violent change in price movement is called transitory volatility and can be terrifying to the trader or investor. Those holding long positions in big drops become frightened and those holding short positions in big drops become euphoric. Since these periods of transitory volatility tend to be short-lived, only the most nimble trader is prepared to take profit advantage from them. That said, every trader should become familiar with the concept of volatility, as it will affect his trading in some way.
Factors underlying fundamental volatility include anything that can cause the price of a given trading instrument (security) to change. For example, in commodities, the most important factors are cash market supply and demand conditions. For bonds, the critical elements underlying fundamental volatility are interest rates and the credit quality of the bond issuer. Unexpected changes in any of these elements generate fundamental volatility in the instrument.
For transitory volatility, the most important factor relates to the demands of impatient and uninformed traders who cause prices to diverge from fundamental values. Although such fundamental values are often not taken into consideration with technical trading techniques, it is critical for the trader to understand and exploit this deviation from what is called mean reversion. In other words, trade while the sun shines and trade what you see, but don’t think it is going to last forever, because it won’t.
What can you do to arm yourself against volatility swings? Many traders become dizzy, agitated, frustrated and impatient in the face of volatility because they are either holding and hoping or trying to anticipate what will happen. Also, the majority of traders are not skilled enough to use volatility to their advantage to take profits from movements that result from the actions of uninformed and impatient traders.
Thus, for most traders, the following steps are recommended in the face of volatility:
- Absolutely avoid any attempts to top-tick or bottom-tick. You get one chance in your trading lifetime to get that right, and most simply cannot do it.
- If you are a trend trader and the market is not trending, wait. Wait for the market to reveal itself by breaking up or down out of its trading range.
- Remember that shorting is not the same as selling longs.
- In market downdrafts, sell only if the reason for your entry is violated.
- Use stop-loss orders. Stops are absolutely critical for managing risk exposure and for protecting against unexpected volatility. You cannot control what the markets are doing or are going to do. You can, however, control your exposure by the use of stops and by position-sizing.
- When unsure, reduce your position size so that you are working at a risk-reward ratio that allows you to sleep at night and does not get you into a state of stress. Remember that capital is not just financial, and that emotional drawdowns are just as dangerous as financial drawdowns.
- Be very selective in what and how often you trade.
- Try to keep your emotional rat brain under control by not allowing yourself to go too far into emotions of either euphoria or despair. Stay strong and centered.
Having a basic understanding of stock market volatility and taking the steps recommended above will go a long way to making you a stronger, more profitable and better-grounded trader.
Life is like a grinding stone: It can polish you or pulverize you, depending on how you position yourself… Larry De Angelo
Until Next Time,
Good Trading and Brain On!
Janice Dorn, M.D., Ph.D.
janice@thetradingdoctor.com
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