Dr. Brett Steenbarger - Identifying Trading Volatility, Range & Targets

Dr. Brett Steenbarger, author of Traderfeed recently posted a series of very helpful articles regarding target identification. A couple of the posts are expected to be available only for a limited time. I am preserving the series of posts in my blog as a source of for future reference.

Thank you Dr. Brett for your educational posts. They continue to inspire, motivate and assist all levels of traders and help us improve our odds to succeed in this difficult business.

Here follows the series of posts from Traderfeed:

Wednesday, March 31, 2010
Every Trade Idea Includes Hidden Volatility Assumptions

This will begin a series of short posts on price targets, why they're helpful, and how I calculate them.

While many traders pay close attention to their entries, they don't always crystallize their ideas as to how far the market is likely to move in their direction. Without a clear idea of price targets, it's easy to exit positions too quickly or overstay your welcome and see moves in your favor reverse against you.

Price targets incorporate assumptions not only about directionality, but also volatility. This is where most traders get hung up: they focus on market direction, but their assumptions regarding volatility are hidden--and often inaccurate.

This is a very important concept: every trade idea embeds a hypothesis about *both* direction and volatility. When we calculate the risk and reward on a trade, we're making assumptions about how and how far the market could move in our direction. Bad calls on volatility could be as problematic over time as bad directional calls.

My goal, in part, is to make you more aware, more conscious of your volatility projections when you hold a trade toward a chosen objective or place a stop out point away from your expected direction.

So how can we adjust for volatility? There are two ways, and those will be topics for the next posts in this series.

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Wednesday, March 31, 2010
Defining Effective Price Targets With the Previous Day's Data

In my recent post, I emphasized that every trade idea that includes risk and reward necessarily makes assumptions about both market direction and volatility. Traders encounter problems when they are right about market direction, but either underestimate volatility (and leave potential profits on the table) or overestimate it (and see winning trades reverse on them and often become losers).

So how does one define effective price targets that have a reasonable, known probability of getting hit?
The market itself provides us with some valuable targets.

Going back to late 2002 in the S&P 500 Index (SPY), for example, we find that only about 12% of all days are inside days. The odds are quite good that today's market will take out yesterday's high or low price. If we open somewhere within yesterday's trading range, we can then use our readings of evolving market direction (sector behavior, intermarket relationships, sentiment) to handicap the odds of hitting one of those price levels before touching the other one.

The advantage of using yesterday's data to frame today's targets is that we're allowing the most recent estimate of volatility guide our expectations about today's volatility. We can then update today's relative volume as the market is trading to modify those expectations as needed.

For instance, if we define yesterday's average price simply as the average of yesterday's high and low, we find out that, since late 2002, we've traded today at yesterday's average price about 60% of the time. That is useful information for those occasions where we open above or below yesterday's average price, but cannot sustain buying or selling. We can then target a reversion to the average price of the previous day, because we cannot sustain value higher.

Interestingly, the statistics are similar for weekly data, so that we can expect this week's trade to take out either last week's high or low and can expect a high proportion of occasions in which the current week's trade will touch last week's average price. This can be helpful in framing targets for swing trades.

The odds of exceeding highs or lows are even higher when we frame overnight highs and lows as initial targets for futures contracts. Well over 90% of days take out either their overnight high or low, so when we open within the overnight range, a worthwhile initial trade is to play for one of those levels once we see evidence of a directional bias to the day's trade.

The beauty is that, in using these levels, we automatically adjust assumptions regarding volatility based on how the market has traded most recently.

In my next post we'll see how we might build upon that.

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Wednesday, March 31, 2010
Bonus Post: Calculating Price Targets

As I mentioned earlier today, in appreciation of the generous readership, I thought I would share some of my ideas and methods for calculating price targets. If you're new to this topic, it would be helpful to review my prior posts on hidden volatility assumptions and defining effective price targets with the previous day's data.

What we saw in that latter post was that using the previous day's high, low, and average prices provides us with relatively high probability targets for the current trading day.

In my own work, I do not use the average price as defined in the post (H+L/2). Rather, I use (H+L+2C/4). This is the "pivot" level that I post each morning for SPY via Twitter. This overweights the closing price relative to the prior day's high and low, so that--on average--the pivot price will be closer to the current day's open. Going back to late 2002 (N=1894 trading days), my Excel calculations show that we have touched the previous day's pivot on 70% of all trading days.

For this reason, the previous day's high, low, and pivot prices are key near-term price targets for my trading. As I mentioned previously, even closer price targets are the overnight high and low prices from the ES futures.

If I anticipate a slow trading day with a narrow price range and we open in the middle of the overnight and prior day's ranges, I will look for trades to take out the overnight high or low price and then the previous day's high or low. If I anticipate a slow trading day and we open nicely above or below the overnight and prior day's pivot levels (for overnight "pivot" I use the day's VWAP), I look for a move back to VWAP and then the previous day's pivot if buying or selling can't be sustained.

If I anticipate an average or busier trading day, I look toward more distant profit targets. Below is one way of calculating those that builds on the previous post.

FORMULAS FOR CALCULATING PRICE TARGETS

* Let us call the difference between yesterday's high and low prices R, for range. That means that the difference between yesterday's average price and yesterday's high is 1/2 R and the difference between yesterday's average price and yesterday's low is 1/2 R. (We're using average price, not the pivot level, for this calculation. More on pivot-based calculations in the next post in the series).

* If we calculate (yesterday's average price + 3/4 R), we will get a price level above yesterday's high that we'll call R1. If we calculate (yesterday's average price - 3/4 R), we will get a price level below yesterday's low that we'll call S1.

* Going back to late 2002, the odds of hitting R1 or S1 during today's trade are 67%. Two-thirds of the time, we'll hit R1 or S1. It's a high probability target if volume is average or better.

* If we calculate (yesterday's average price + R), we will get a price level above R1 that we'll call R2. If we calculate (yesterday's average price - R), we will get a price level below S1 that we'll call S2.

* Going back to late 2002, the odds of hitting R2 or S2 during today's trade are 41%. We want to see above average relative volume (and today's volume > yesterday's volume) to assume that we'll touch R2 or S2.

* If we calculate (yesterday's average price + 5/4R), we will get a price level above R2 that we'll call R3. If we calculate (yesterday's average price - 5/4R), we will get a price level below S2 that we'll call S3.

* Going back to late 2002, the odds of hitting R3 or S3 during today's trade are 26%. We would need to see significantly above average relative volume (and today's volume significantly > yesterday's volume) to assume that we'll touch R3 or S3.

VARIATIONS OF THE ABOVE WORTH RESEARCHING:

* Instead of using yesterday's average price as a base for calculation, you can use the traditional pivot formula of (H+L+C)/3.

* Instead of using yesterday's average price as a base for calculation, you can use today's open. That is especially helpful when the overnight session leads to an opening price far from yesterday's average price.

* Instead of using R values based on yesterday's trading range, use the average trading range from the prior N days. My research shows some benefit to going out several days, but returns are diminishing out to a five-day lookback.

Regardless of your calculation method, you will find that R increases as the market's volatility increases and decreases as the market's volatility wanes. This automatically adjusts your price targets for the market's most recent volatility.

Going back to late 2002, yesterday's volatility correlates with today's volatility by a whopping .75. That means that we can predict more than half of the variance in today's volatility simply by knowing the prior day's trading range. If we go out to a five-day period, the correlation between the prior five-day's average range and today's range has been .80.

Once you become good at tracking today's volume relative to yesterday's (or the prior five days'), you can make very reasoned estimates as to which levels we're likely to hit during the day. That considerably strengthens our exits and helps us maximize our risk/reward.

This post and the next one (tomorrow) will remain on the blog for a limited time. If the research is of interest, you might want to print out the post or copy the relevant data.

Thanks again for all the interest and support--

Brett

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Friday, April 2, 2010
Bonus Post #2: A Different Method for Calculating Volatility-Adjusted Price Targets

My recent bonus post explained one of the ways that I've found helpful to think about and calculate price targets for the trading day. As background for this topic, please check out the posts on defining effective price targets and the importance of volatility in trade planning.

This will be my second and final bonus post on the topic. As with the earlier one, I will be keeping it on the site for a limited time as a thanks to current readers. If the ideas interest you, you might want to print the post out or jot down the relevant ideas.

In this post, I will explain how I calculate the daily price targets that I post each morning via Twitter. I'm in the process of tweaking my weekly target calculations and will wait for a future occasion to share those.

CALCULATIONS

The calculations begin with the day's pivot level, as I define it:

Pivot = (H + L +2C)/4

Today's pivot price is defined as the average of yesterday's high price plus yesterday's low price plus two times yesterday's closing price. That gives us an approximation of yesterday's average trading price.

Going back to late 2002, we touch the pivot level during today's trade on 70% of all trading days. This is a useful "reversion" target if we open above the pivot, but cannot sustain buying or if we open below pivot and cannot sustain selling. (The current day's VWAP for the index futures contracts is generally my first reversion target).

As mentioned in the earlier post, the overnight high and low price and the prior day's high and low are generally my first price targets. Along with the pivot level and VWAP, those are generally targets for the first trades I will place during the day. Once I know those targets, it's a matter of: 1) discerning the balance between buying and selling sentiment, as well as sector and intermarket dynamics, to gauge direction; 2) assessing today's volume relative to yesterday's (and the prior five days' average volume) to gauge evolving volatility; 3) executing the trade in the identified direction at a price that provides a favorable level of reward relative to risk; and 4) holding the trade to the price target most likely to be hit given the market's current strength and volatility.

(The above paragraph is a concise description of how I trade on the day time frame).

The price targets above the prior day's high are identified as R1, R2, and R3. The price targets below the prior day's low are identified as S1, S2, and S3.

To calculate this levels, we need an estimate of recent volatility. That estimate in my calculations is the median daily price range for the past five trading sessions in SPY. Thus, each day we calculate the Daily Range: DR=((H-L)/O)*100. That is the difference between the day's high and low prices divided by the opening price multiplied times 100 (to give us a percentage). The Volatility estimate (V) for our calculations is the median of the prior five days' DR values.

As I mentioned earlier, going back to 2002, the median volatility for the prior five days correlates with today's volatility by .80. Knowing V gives us a good idea for today's DR.

So now we can define our R and S price targets:

R1 = Pivot + (.60*V)
S1 = Pivot - (.60*V)

Going back to 2002, we touch R1 or S1 about 84% of the time. If the volume today is anything like yesterday's volume, R1 or S1 should be hit during the day.

R2 = Pivot + (.80*V)
S2 = Pivot - (.80*V)

Going back to 2002, we touch R2 or S2 about 66% of the time. If today's volume is above average, we should hit R2 or S2 during the day.

R3 = Pivot + V
S3 = Pivot - V

Going back to 2002, we touch R3 or S3 about 50% of the time. If today's volume is meaningfully above average, we should hit R3 or S3 during the day.

R4 = Pivot + 1.2 V
S4 = Pivot - 1.2 V

Going back to 2002, we touch R4 or S4 about 36% of the time. We need to see volume today much greater than the recent average volume to have confidence in hitting R4 or S4.

Obviously, you could define R5 and S5 levels (and beyond) accordingly for relatively rare occasions of high volume trending and range breakouts.

NOTES ON THE CALCULATIONS

These price levels were calculated and tested empirically in Excel using historical data. They are not based on any Fib or any other numerical scheme.

A worthwhile tweak on the above methodology would be to use today's Open price in lieu of the Pivot for the calculations.

Another tweak substitutes weekly data for daily data to use for swing trading.

Another tweak is to adapt the formulas to different trading markets.

Knowing how far a market is likely to move in a direction is invaluable in guiding the placement of stop and exit levels and calculating the risk/reward parameters of a trade. By adjusting price targets for recent volatility, traders can adapt quickly to faster and slower market conditions. The price targets are not necessarily hard exit levels; rather, they provide anticipation of where those proper exits are likely to occur.

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Friday, April 02, 2010
Clarifications Regarding Price Target Calculations

I've been inundated with questions regarding the first and second posts detailing methods of calculating price targets. Here are responses to the more common questions:

* All calculations are in Excel; Excel functions will calculate medians and averages for you. No complicated spreadsheet programming or statistical software is needed;

* The data come from my archives, which is why they go back to late 2002. It's a sample of convenience that cuts across a variety of market conditions;

* Other values can be used, and I encourage readers to experiment with their own formulas. In place of the day's average price, you could use the pivot level for the day or the day's VWAP. A promising variation is to use today's open and calculate price targets around that;

* The basic approach from my second post can be used for any stock or ETF. You'll simply need to adjust the constant in the formulas for R1/S1, R2/S2, R3/S3, etc. Instead of using .60, .80, and 1.0 as in SPY, for instance, you'll need to define the proper constants for each market;

* Using weekly data instead of daily data will give you price targets for the following week. (Those constants need to be adjusted as well). That is very useful for swing traders. I post weekly price targets for SPY each Monday morning via Twitter;

* Formulas for the ES futures will look different, because the pivot and volatility calculations will incorporate overnight trading data. With SPY, there is no overnight data embedded in the formulas.

Hope that's helpful. My goal in providing the formulas is to encourage you to think of trading in a different way, with an emphasis on exits and targets, not just entries. If my posts raise questions and lead you to explore the data on your own and find relationships different from the ones that I have shared, I will have succeeded in my mission!

Thanks as always for the interest and support.

Brett