Today’s Trading Lesson From TradingMarkets

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Each night we feature a different lesson from

TM University.
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any questions.

Brice

Larry Connors
Teaches: How To Adjust Position Size Using The VIX


By Larry
Connors

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)
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:
Y
es.
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.