How to trade the new volatility

Finding successful trades is just a part of the profitable trader’s job.

He or she must also manage volatility … the market movements that have the power to, in an instant, make us fortunes or wipe us out.

This week I’d like to look at how traders traditionally protected themselves from volatility, and how the new global marketplace is changing the rules.

If we don’t learn about this new world order … we’ll not just get left behind – we’ll be wiped out of the game …

Nowhere to run to, baby, Nowhere to hide …

The traditional wisdom was to trade with a diversified portfolio. And if you’re a day trader, to keep your exposure well spread out across diverse markets.

A diverse portfolio is one that consists of uncorrelated assets – i.e. asset that don’t move hand-in-hand all the time. By doing this, we can reduce volatility. It muffles the sudden ups and downs of the market.

All very sensible.

The problem is that correlations aren’t set in stone. They tend to ebb and flow. In periods of panic, they tend to increase, as herd behaviour takes over, and traders rush to sell danger and buy safe havens. And there are many other geo-political and economic factors that can affect what correlates with what, and by how much.

But something interesting has been going on with market correlations in recent years. And if we don’t recognize this, we could, at best, miss out on the benefits, or at worst, find ourselves on the wrong side of the market.

First, lets take a quick look at how correlations are measured

Correlation is measured on a scale of -1 to +1. If two markets move perfectly together, then the correlation will be +1. If they move together, but one goes down as the other goes up (and vice versa), then the correlation will be -1. And if they show no correlation at all, then the figure will be 0.

So, our perfectly diversified portfolio will be filled with trades on markets that have a ‘0’ on the correlation scale.

That’s the theory, but now lets look at what’s actually going on in the real world …

Below is a chart from Wharton finance professor Jeremy Siegel, showing correlations between the S&P500 and six other major markets since 1965.

What sticks out on this chart is how, during the 1970s, the 80s and most of the 90s, we’re looking at correlations between +0.6 and -0.4. The only markets showing anything like a consistent correlation are the EAFE (which is an index of developed world stock markets, which it’s hardly surprising would be closely correlated to the S&P).

But then, around 2000, suddenly markets (with the noticeable exception of gold) are swinging rapidly towards the extremes of +1 and -1 correlation.

Here’s another chart taken from a paper written by Todd Moss (vice president at the Center for Global Development and former deputy assistant secretary for Africa in the US Department of State):

Again, the trend towards greater correlation between global markets since 1990 is undeniable.

What is going on?

Siegel describes it as the “Nowhere to Run, Nowhere to Hide” market. When one market has a bad day, it affects other markets around the planet – a bad day in Asia rolls over into losses in Europe and the US.

And, as the chart above shows, it’s not just indices that are affected. When stocks plunge, the prices of commodities (the red line on the chart above) head lower.

There are two key reasons for this increased correlation …

• The number one reason is globalization. Investors today buy and sell in all the world’s markets and react to high-speed communications that hit all traders around the planet at the same time. Plus, business is global – the indices of developed and emerging stockmarkets are filled with global industries.

• Since the financial crisis, national and international economic news has become far more important than any specific data coming out about individual companies or particular industries.

So, does this increased correlation actually matter?

The simple answer is: yes!

Not only does this huge growth in market correlation matter – I believe that the future of trading is in taking advantage of these correlations.

As I said earlier, correlations will ebb and flow – but there’s no denying the trend to more consistent correlations. And any trader in their right mind who spots a trend knows that where there’s a trend – there’s money to be made.

First, let’s just remind ourselves of what a correlation can tell us, and what it can’t tell us …

We mustn’t get correlation and causation mixed up.

As every rifle-wielding redneck likes to remind us, when they’re looking at the correlation between gun ownership and homicide … correlation and causation aren’t the same thing.

Just because ‘Y’ rises when ‘X’ rises, doesn’t mean that X is causing Y to rise. There is usually some shadowy ‘Z’ factor that’s causing both to move. And it’s mapping out these causal links that notoriously tough. That’s why tobacco giants managed to deny any link between smoking and lung cancer for so long.

And it’s the shadowy nature of these causal links that makes the ebb and flow of market correlations.

But, if we can’t find markets that will give us a correlation anywhere close to ‘0’, instead we must balance our trading, by buying markets with a negative correlation (to cancel each other out) … or buying and selling markets with a positive correlation (again, to cancel each other out).

For a long time, I’ve banged on about Martin Carter’s MRP Strategy, which is the only simple method I’ve come across to trade this way. Martin’s system is currently closed to new members while it’s undergoing some exciting new developments – I’ll let you know as soon as there’s some news on this.

In the meantime, I’d urge you to consider correlation trading and how we can manage volatility and diversity in the current global markets. I’d love to hear your thoughts on the subject – please leave your comments below …

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