Larry Connors Teaches: How To Adjust Position Size Using The VIX
This is
an edited transcript of a TraderTalk workshop conducted for TM members on July
18, 2002, by TradingMarkets CEO Larry
Connors. For charts, please click here.
Brice
Wightman: Welcome to
TraderTalk. This afternoon we are fortunate to have TradingMarkets CEO
Larry Connors. As many of you know, he is the author of several books
including “Street
Smarts,” “Trading Connors VIX Reversals,” and
“Investment
Secrets of A Hedge Fund Manager.” He also recently completed a new video,
“Buy
The Fear, Sell The Greed.” Market volatility has increased the past few
months and with it, not only the
potential for increased profits, but also for increased losses. To tell you
more about how you can use this increase in volatility wisely in your trading,
here is Larry.
Larry
Connors:
Good afternoon everyone. Thanks Brice (for sucking up to me). Let’s get started.
Today I had planned to talk about adjusting position size in a volatile
market. I will cover that but I first want to talk about the CVR signals, as
they pertain to the market today. Obviously, the past two weeks, the market has
gone through an extremely hard downturn. In fact, as I was thinking this out
last night, I don’t remember seeing a market sell off this hard without
concrete news behind it.
Previous hard downturns over the past decade have been event-driven. If you
look at early 1994, Greenspan was tightening interest rates. 1998 saw the
long-term capital debacle and 2001 saw the WTC event. This short-term rapid
downturn has not been the result of any one direct event and makes it feel at
least to me, a bit different.
With that said, my market timing tools,
especially the CVR signals, are used to gauge when market reaches extremes and
historically reverse.
We reached this extreme about a week ago, yet the selling continues. I’ve seen
this persistency of movement occur a couple times every year (in both
directions) and it looks like it is occurring again. With each selloff, we
increase the likelihood of a sharp reversal. But in the meantime, it’s
painful. If you are uncomfortable with the risks involved trading at this time
(using the CVR signals) it’s best to stand aside. You will likely miss the
reversal when it does occur, but in the meantime you will not deal with the
drawdown if the selling continues.
I’ll take questions on this and anything else we talk about, after we are
completed. Please send me your questions. I’ll
do my best to answer as many as possible. Now let’s dive into the scheduled topic, which is adjusting your position size
based upon the volatility of the market. I briefly mentioned this in my
Battle Plan piece this weekend and a number of members sent me questions
about it, so I would like to use this opportunity to expand on this.
Over the past 90 days, the volatility of the market has approximately doubled.
This means that the average daily range of most stocks has doubled vs. where
it was in March. This is significant. On the negative side it means when
you’re wrong on your trades, you’re either losing double the amount of what you
were losing three months ago, and/or you’re getting stopped out twice as much
vs. March. On the positive side, it means when you are correct (and you’re
letting your profits run), you’re likely making twice as much as what you were
making in March. In order to smooth out these swings, I’m going to teach you
how to use the VIX
(
$VIX |
Quote |
Chart |
News |
PowerRating) to adjust your position size, no matter what volatility is
on any given day in the future.
Before I do this, I just want to mention one more thing: Volatility nearly always
reverts to its mean. In a sense, you can view the mean as being gravity. In
March of this year, with volatility getting lower and lower each day, Wall
Street analysts were saying that we were incurring “a structural change in the marketplace
and that volatility would decline for years.” It’s now four months later,
and last night I heard on one of the financial TV
channels that “this increased volatility is here to stay.” None of us knows where
volatility will be in the future. But we can get a pretty good gauge of it by
looking over a longer-term period of time.
The best way is to take the 100-day moving average of the VIX. If
you look at where the VIX has been over the last 100 days, it gives you a
guideline as to what a more normal reading will be. From this normal reading,
we will adjust our position size accordingly, based on the daily reading of
the VIX. When the VIX is well above this 100-day moving average, we will
adjust our position size downward (to adjust to this increase in volatility).
When the VIX is well below the 100-day MA, we will increase our position size.
If you look at the 100-day MA of the VIX today, you will see it is in the 25%
range. If the VIX is at 50% today, it would mean that volatility today is
double where it was vs. the past 100 trading days.I’ll now give you some general
guidelines using today’s volatility to adjust
your position size.
Let’s assume you normally trade 1000 shares of a stock. At
a VIX reading of 50%, you will trade half this amount (because volatility has
doubled). At 45% you will trade 600 shares. At 40% you will trade 700 shares.
At 35% you will trade 800 shares. And at 30%, 900 shares.
Should the VIX drop to 20% (and the 100-day MA remains at 25%), you will trade
approximately 1200 shares (all this math is approximate). Obviously, the VIX
only takes into account the anticipated volatility of the stocks in the OEX,
but it does give you a pretty good measurement of what overall market volatility is
expected to be. Should the stock you trade have some
event such as earnings, takeovers, etc., hit it, you will want to take that
into account in adjusting position size. The main goal here is to look at the
broader market and adjust your position size, based upon its daily volatility.
Question: Why use 25%…?
Connors:
To make sure everyone
understands, if you look at the 100-day MA of the VIX, it is at approximately
25%. This is the baseline we’re using to adjust our position size to.
Question: Is there another way to adjust your position size, based upon the
volatility of an individual stock?
Connors:
Yes. Simply look at the 100-day volatility of the stock
and use this as your baseline. Then look at the 6-day volatility of the stock.
Use the same guidelines
as above. For example, if the 6-day is double the 100-day, you want to adjust
your position size by half.
Question:
Do you use Kevin Haggerty’s Volatility Bands to exit a
trade? Can you please tell me who Kevin Haggerty is?
Connors:
Oh yeah, that
guy. No,
I don’t use his bands to exit a trade, but I do see the wisdom of using them.
In fact, I have an outside researcher looking at applying the bands with the
CVR signals as a possible exit/trailing stop strategy.
Question: Do you use an exponential MA or a
simple MA?
Connors:
I use a simple MA for
my calculations.
Question: Larry you
were talking about persistent selling. Have you seen a current situation with
accounting issues at a time when earnings are so important?
Connors:
I personally don’t
equate these accounting problems with the same level of seriousness that Long
Term Capital created in 1998 or that September 11 brought. This is why
the intensity of this sell off somewhat surprises me, but it is also why you
need to have protective stops in when you trade.
Question: If you use
the 6-day volatility of a stock as compared to the 100-day volatility,
wouldn’t that potentially have you putting in a larger position before an
explosive move?
Connors:
Yes.
But just because something is trading at a lower reading on a 6-day than
its 100-day, does not necessarily mean that the move is going to happen the
next day. Each daily movement will smooth out the position size, but your point
is correct and should be considered as you adjust your positions.
Question: How do you locate individual VIX
readings for individual stocks?
Connors:
I don’t look at the
VIX reading for individual stocks, but I believe you can find those numbers at
www.hamzeianalytics.com
Question: Is there a length of time that you
won’t trade, even if you have a CVR 3 for many days?
Connors:
The CVR 3 is the signal I rely upon the most. Overall, it is the best
performing of the CVR signals, but it tends to be early those few times each
year that we have these persistent one-way moves. With that said, I’m willing
to assume the risk of being too soon and stopped out numerous times, as is
occurring now, in order to be there for the many times that the signal is
correct.
Question: Do you
find merit in adjusting position size, based upon the number of VIX signals?
Connors:
Yes, but it gets more complicated than that. I cover a
lot of this in
my video course (sorry to do a Landry and make this an ad) but a CVR 3
alone is more powerful, in my opinion, than a CVR 1 and 2 combined, which are
weaker signals. Also, since 1999, I now use another nine CVR signals and some of
those combined are more powerful than others.
The main point here is that more signals in one direction give you a higher
likelihood of success. In fact, based upon our testing five or more CVR signals,
no matter what their combination, has led to to profitable moves a little
bit over 70% of the time within three days, over the past nine years. There is no
guarantee that this will continue, but it does show that the more signals you
have pointing in one direction, the better your chances of the trade moving in
your direction within a few days.
Question: Aren’t
you, by suggesting a reduction in size if volatility increases, implying that
your overall trading is losing money? If not, assuming you are a profitable
trader, why not leave size alone?
Connors:
I’m making no assumptions on past profitability. My goal by doing size
adjustment is to be able to smooth out the returns over a longer period of
time.
Question: We all
want to preserve cash for the turn. Yet we are willing to take some risk to
be there at the moment of the BIG reversal. Do you use call options to keep a
position on for that event?
Connors:
No. I have learned from experience and more importantly
from Tony Saliba and his head trader Joe Corona, that long premium (i.e., long
calls) is overall a losing game. Also, please remember what is going on when
the market reverses and rises sharply. Volatility will implode and even though
prices are moving in your favor, volatility and time are moving against you and
are eating into your move. That is why I would prefer to be long the underlying
market and use stops to protect myself.
Question: Lately,
I
find myself getting stopped out frequently, sometimes twice, where the
position ultimately goes in my direction without me. How many times do you
re-enter a trade (once, twice, unlimited) before you throw in the towel? Also, do you
use the original entry point to enter or wait for a new signal? For instance,
you have a narrow-range Trap Door entry, but get stopped out on a subsequent
wide-range bar. Do you use the original entry point or a new entry point based
on the wide-range bar?
Connors:
You’re not alone in seeing yourself getting stopped out frequently and the
position reversing in your original direction. Let’s talk about what the
market will usually bring over a 12-month period of time. Within that time
frame, you’ll see periods of low volatility where it will be next to impossible
to make any money because there is no range. You will see markets that move
straight up (as they did in March); you will see markets that move straight
down (as they have done over the past month).
But, the majority of the time the markets simply live in a state of
equilibrium which means a state of gradually trending and normal swinging back
and forth. Right now, we are seeing a market that has become very oversold,
very volatile and very reverse driven. Within a 12-month period of time this
will happen one or two times. And this one of them. Usually most traders will
attempt to adjust their entire methodology in a reactive mode, based upon these
extremes.
This is not the correct thing to do. Slightly adjusting for example by
position size is correct. But to deviate from your overall plan because of a
short-term abnormality is usually not the smartest thing to do. The thing to
do is to look ahead and ask yourself what will the market likely bring over
any 12-month period of time and then create strategies and money-management
strategies to fit within that framework. This is a very difficult exercise but when
done correctly, it allows you to live within short-term
times where market behavior is abnormal, as we are seeing right now.
I’m going to take a few last
questions and then we will wrap this up.
Question: When you
notice volatility has increased, when would you advocate adding to a position?
When it moves in your favor? What are your rules here? Indicators?
Connors: I never
advocate adding to a position when volatility increases. I advocate decreasing
position size. Also, I do not add to winning positions. I’m looking to scale
out of winning positions. And the more aggressive the move is in my favor,
the more aggressive I become in looking to take profits.
Question:
Your answer about options makes sense.
However, the other question about constantly getting stopped out seems
to be the norm among most of us. Perhaps the real folly is trying to catch the
moment of the BIG reversal and not waiting for a new trend (blue
arrow). I
would like to trade and especially be there for the BIG move, but it seems like
a zero-sum game. How do you manage to do it successfully?
Connors:
This is a very good
question and it gets to the heart of whether or not you should be a
swing/momentum trend trader or a reversal trader. Dave
Landry, Gary Kaltbaum
and Tim Truebenbach are successful swing/momentum traders.
Kevin
Haggerty, Don
Miller and myself are reversal traders.
Both styles can be extremely successful, but you can’t say one is better than
the other. The key is to understand how you are wired, how comfortable you are
trading either style, and whether or not you have the strategies to be able to
successfully trade that style. Even though Kevin, Don and I trade the same
styles, we use different strategies. I believe the reason for our success has
less to do with the strategies and more to do with our money management and
discipline.
We each look to buy/sell market
extremes, attempt to minimize risk, and we basically do the same thing, day
after day after day. I can safely say that none of us makes money every day at
trading like this. But the three of us have a combined 60+ years of experience
(most of it Haggerty’s) doing this, and it’s the style that we have found the most
success with. Whether or not this style works for you is 100% your decision.
The only thing I will strongly urge you to do is to select one style and
master it. That’s the key to success in most walks of life, and it’s one of the
keys to success at trading.
I want to thank everyone for
spending the last hour with me. If you would like any more questions answered,
please email them to me directly. I’ll answer
you by Sunday. Thanks again.
Brice Wightman:
Thanks, Larry. This chat is archived, lower left of TradersWire, just click
“archives” for July 18, 2002.