The E-mini Trading Professor

Archive for the ‘price volatility’ Category

I use a portion of the stochastic formula to exit my e-mini day trades and, for the time being, I thought I would introduce you to the concepts and premises of stochastic measurement.

Stochastic is an oscillator that is very popular and has been around for several decades. It is a price oscillator tracking overbought and oversold conditions. It is often used in the red/green light trading systems which can cause problems for e-mini day traders unless they understand how stochastic works, why it was created, and what it was designed specifically to track.

Stochastic was written by George Lane and is a true oscillator which means it was primarily designed to track either overbought or oversold price conditions in a range.

In the e-mini stock market, the term “overbought” means that it can be assumed everyone who wanted to buy the stock is now fully vested and there are no more buyers or insufficient buyers to move the stock up.

Oversold is just the opposite, there are insufficient sellers to move the stock down.

The reason oversold and overbought is critical in sideways markets is that the shift from buying to selling can happen rather quickly.

George Lane wrote the indicator Stochastic formula based upon the presumption that as a run moves up (or down) a stock will close nearer to its high as buyers keep rushing in to buy the stock. But as momentum tapers off or buyers become scarce, then a stock will close lower from the high price for the day.

This is a presumptive statement that works in trading range markets. The theory fails during strong rallies and velocity markets because stochastic will move into the overbought area or oversold area signaling an exit just as the stock begins a huge run.

Therefore, Stochastic should not be used during momentum or velocity markets, platform markets, or bottoming markets as it will create a premature exit signal just as the stock is about to run up strongly.

During a velocity market you should use a different indicator than stochastic. Instead switch to an accumulation indicator and quality indicators as these will help you get into the stock early before the big moves up.

The Stochastic Formula and what it is intended to reveal:

There are 2 lines for the George Lane stochastic formula: %K and %D usually represented in red and black lines on charting software. First, the K line must be calculated.

K=100((C-L)/(H-L))

Where K+ the location of price relative to the current price range

C= the last close price

L=the n-period low price

H=the n-period high price

n=any time period specified

K is smoothed twice with a 3-period SMA which creates the %K line, usually black on charts.

Then %K is smoothed again with a 3-period SMA to create %D line which is usually red on charts. Only the %K and %D lines are used in the chart analysis. So you will only see 2 lines to represent the 3 lines in the formula. Because it uses a fixed time period to period calculation, the lines can jump and move erratically if price fluctuates significantly.

Most stochastic indicators have predefined 80% overbought line and 20% oversold line on the chart. A few charting software programs allow you to move the lines to whatever percentage you wish.

If you are a beginner, simply use the settings of 80% and 20% for a trading range market.

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The last couple of summers have ushered in tremendous price volatility when day trading the ES e-mini contract. There were times when the market volatility was so extreme that normal backing and filling operations (market noise) could easily stop you out of your trade. In fact, if you chose to trade during these volatile periods, you would need nothing short of 20 tick stop loss point. For me, such wide stops increased my risk tolerance to a point where many days were too volatile for me to trade. On the other hand, if you were lucky the market moved in the direction of your trade and you could realize fantastic profits. The key in the last sentence is “luck,” and luck is no way to day trade. So many days I was relegated to watching the market and hoping the market volatility would settle down some, and some days it did and there were good trades to initiate.

In recent weeks the markets have not been very volatile and we have experienced exactly the opposite phenomena as the previous two summers. So market volatility plays a major part in your ability to trade and to select trades. There is, in essence, there is a “sweet spot” in price volatility where traders can prosper. It is important to be able to recognize just where that sweet spot resides, and how to trade an optimal market volatility conditions.

For me, I like to use the Average True Range to get an idea of the market volatility that I can expect on a given trade. Like most things, the Average True Range is not a foolproof system for gauging market volatility, but it gives me a good idea as to what the market volatility has been and buying any unusual trading circumstances what I can expect based upon the last sequence of bars under measurement. I usually use a setting of 14 for the Average True Range.

A rating all about 2 1/2 or 3 seems to give day traders an optimal chance to earn sizable profits while minimizing the amount of risk tolerance a trader must endure. In my trading, as the Average True Range exceeds 4.5 or 5, I generally find myself on the trading sideline past this level of volatility presents too much risk for my appetite.

But there are other measures of market volatility that are worth a look, too.

The VIX is an indicator distributed and calculated by the Chicago Board Options Exchange. The VIX is a weighted basket of option prices based upon the S&P 500 index. While the VIX is directly related to options and option prices it can still be very useful for most traders because it indicates the implied market volatility of the S&P 500 index over the next month. It is often referred to as the “fear index” as it does not indicate a bearish or bullish bias. Rather, it implies in percentage points the amount of potential movement and the S&P 500 index over the next 30 days. As you might guess, this is a very closely watched index and is even traded as such. In my trading, I don’t have any strict interpretations for using the VIX in my intraday trades, but I am mindful of what the VIX numbers are and the potential for movement they may or may not represent. Obviously, a high reading on the VIX, say 20, implies a potential for sharp movement of 20%, either up or down, in the next 30 days. In essence, a VIX reading of 20 warns the intraday trader that there are indications of pending market volatility. That in itself is something that is good to know.

So if talk a little bit about actual volatility and how to much volatility can make trading very difficult and a very stagnant market, with low market volatility can make trading profitably just as difficult. We have talked about a “sweet spot” in the Average True Range readings that seem to be optimal for trading, at least for my style of scalping, or intraday trading. We also discussed the VIX, which is not directly related to chart trading but can be very helpful as an advisory indicator. We have concluded that sometimes the market can be too volatile to trade effectively and by the same token, it can be not volatile enough to be an effective trader. In short, market volatility is a variable that must be considered carefully and compensated for in a day trader’s daily endeavor.