Okay, okay, enough already. You all want the secret ingredient. The fact is that in Part 3, a couple of you, based on my hint (nice work guys), were able to guess what the secret ingredient is. But just in case you are just now picking up this series, you might want to start by reading Part 1 and Part 2.
The secret ingredient is volatility. I know, what a disappointment. You were probably hoping for some new indicator with a fancy name. The fact of the matter is that most of what makes a trader profitable in the market has already been discovered. It is simply learning how to use these things that makes the difference. I am here to help you learn how to use volatility, or at the very least, learn how it affects a stock (or market’s) ability to trend or mean-revert.
Volatility is going to be key in determining whether you should be looking for daily follow-through or daily mean-reversion.
Volatility can be measured in a variety of ways, but for the formal approach, here is the wikipedia link.
To keep things simple, I will be using a relatively standard formula for measuring historic volatility:
Historic Volatility = (Standard Deviation(log(Close/Yesterday’s Close))30)*SquareRoot(252)
In the above formula, 30 is equal to the length of the period at which we are looking back, and 252 is equal to the number of trading days in the year. 30 is adaptable meaning that to measure historic volatility we can look back at as little or as long a length of time as suits our purpose.
We could certainly use ATR to measure volatility, or TSI, as Danny and David Varadi have recently written about, and we would still only be scratching the surface. Jeff Pietsch from Market Rewind has a great article on this subject here where he ranks historic volatility rather than using a raw measure (or “fixed level analysis”, as he calls it).
I like to keep things simple in order to build a strong foundation of knowledge. Once the foundation is established, then we can get more complicated. (In the markets, always remember that more complex does not necessarily equal better.) Therefore, I will continue to use a raw measure of volatility applied to a basic measure of follow through (trendiness) or mean reversion. I trust that my readers will benefit from this bottom up approach.
Honestly, I’m tired this evening, so before I present the results of the tests using volatility to switch between daily-follow through and daily mean-reversion, I want to show a chart of SPY with 30 day historic volatility plotted beneath it. Examine it for the relationship between volatility, trendiness, and mean-reversion.
I promise that the next post will have some cool statistics.
Jump to Part 5: Using Volatility to Switch between Follow-Through and Mean-Reversion Strategies.
great stuff Shed.
next we need to do a series on dispelling the notion that volatility = risk
Agreud.
Great!
However, if you’re going to explain the concept and the above formula is important, at some point, I’ll need some examples of data to put into the formula in order to understand it.
Thanks!
No problem 5-0
i squirted a little.
Ewwww…but I still lol’d.