Classification by trend and volatility

[Samuel_J]

Hi!

Different market conditions require different indicators. For example: trend-following indicators work well in trending times when volatility is low.

According to 'Curtis Faith' book 'Way of the Turtle' you can classify a time series in two dimensions:
1. The strength of the trend
2. The volatility

This gives you four market scenarios which require different indicators.
1. WEAK trend and LOW volatility
2. WEAK trend and HIGH volatility
3. STRONG trend and LOW volatility
4. STRONG trend and HIGH volatility

I am trying to implement this in a system which automatically will classify the state of the time series.
The idea is to look at the last 20 days and measure trend and volatility during this period and from that classify the time series. The classification then determines which indicators to use.

Measure 1:
I measure the strength of the trend by taking the slope of the linear regression line. The regression line is modeled after the price values the last 20 days. After that I divide the slope value by the price of the first day of the period to get a percentual value of the trend. This also normalizes the data.

Measure 2:
I calculate the volatility for the past 20 days. Volatility is a already a normalized measure so I don't need to normalize the data.

Classification:
The equity current behaviour will be classified to either a LOW or HIGH volatility and to either a STRONG or a WEAK trend. Thus, the equity can be classified into four categories.

My question is if this is enough to be able to classify different equities from different markets?
Concerns:
* Indices or currencies will always be classified with a LOW volatility.
* Imagine a time series with high volatility and a strong trend. Now produce a new time series with the same characteristics but with only a quarter of daily price changes. That is, if the original time series increased with 2% a particualr day, the new time series will increase with 0.5%. This new time series will have the same predictive qualities as the first one, but will be classified with a low volatility and a weak trend.

Maybe I should classify by a relative volatility, that is measuring the relation between the short-time volatility and the long-time volatility?

Does anybody have any suggestions of a good way to measure trend and volatility which works across different markets?

With kind regards,

Samuel

 

[grantx]

Sam,

On a very simple level, I don't think it neccesary to change indicators to reflect different market conditions. Assume you are using 5 and 10 day ma's and volatility is average. If the vol picks up you could use, eg 7 and 12 ma; if vol is low, look at 3 and 6 day ma. Just change the inputs/parameters of the indicators, not the indicators themselves.

For relative volatility just use and compare moving averages, eg 10 days, 20 days and 50 days.

As a guess, to determine trend and volatility you could look at the net change on the underlying and and the corresponding period's volatility. For example, +100 points in twenty days, 50% volatility:

+100 x 0.50 = 2.0;

+100 in 20 days, 25% volatility; +100 x 0.25 = 4.0

In other words, the higher the figure, the better for trading.

The numbers would also be relative for a fall in the underlying:

-100 x 0.50 = -2.0,

-100 x 0.25 = -4.0.

Positive results (rising market) could indicate potential for going long; negative results could indicate potential for going short. The higher the number (positive or negative), the less risk.

Grant.

 

[Joey25]

Samuel,

I use 3 things when considering trend/voaltility

1) Curtis's backward-looking ATR measure
2) The option market's forward-looking measure
3) Open in relation to yesterday's high/low

1) ATR (Average True Range)
Calculate: Max (High - Low , High - Previous Day's Close, Previous Day's Close - Low)
Take a simple average of the last 20 days.

This measure for the FTSE is about 100 points.

2) At-the-money implied volatility.

May FTSE settled at 6098 yesterday, with an implied vol of 17.32%
Translating to points use: sqrt (1/260) x 17.32 x 6098 /100 = 65 points.

For indices, the forward-looking measure is almost an "index of fear". Even for large upward moves
the measure tends to fall, whereas on moderate down days the number can go up.

3) Open in relation to yesterday's high/low.

This often requires me to do the opposite of what the trend in measures 1) and 2) may be saying.
1) and 2) may be characterized by a constant fall for a week and then a small inside-day.

A gap open above the high or below the low after this inside-day usually means an explosion in volatility.

Joey

 

[grantx]

Sam,

Missed the obvious. As Joey points out, use the atm implied.

To expand on Joey's point, where he shows the calc for converting the iv to the forward point range, so to speak ("65 points"), I think this represents 1 standard deviation (correct me if I'm wrong, Joe). This is fine as a basis for potential profit range, but for potential risk I would look at 2 or 3 sd's as minimum.

The implied volatility does not hold up particularly well as a predictor of future prices, but it does provide an unbiased measure as a reference point. Start to build a database using Joe's calculation for a new comparative/relative measure.

Depending on your overall strategy, you should be aware of the presence of volatility smiles/smirks/skews/ curves, etc ie the atm iv only reflects atm iv; itm and otm will be different.

"Index of fear". A good description.

Grant.

 

[Joey25]

Grant,

Yes I agree. Curtis also suggsests using 2 X ATR.

With regard to options, I believe when they switched from VOX futures to VIX futures they did something like a weighted sum of vols across the curve to get an overall number (perhaps weighted by the deltas, but I'm not sure)

What I find amazing is that you sometimes get the biggest rise of the year in the S&P and the vol goes down!

Joey

 

[nine]

Vol often falls during rises Joey. It also often rises during falls.

You might gain from thinking about why this could be (think fear vs greed) as it will assist your trading.

 

[grantx]

Joey,

I can’t judge the effectiveness of an average although it is certainly worth considering as an additional reference for comparisons with atm iv and historic vol.

What I do is calculate the average itm, atm and otm implieds by taking an average of 5 strikes for each with reference to delta - itm delta is 0.75, atm at 0.50, otm at 0.25. For example, if the itm strike/0.75 delta is 6500, then I would sum the implieds for 6400, 6450, 6500, 6550 and 7000 and divide by 5.

Nine is correct re the implied going in the opposite direction to the market. However, you may also see put iv’s increasing if the move is particularly strong – the faster it moves up, the greater the severity of a correction, ie put prem’s up due to perceived increase in risk on the downside.

Grant.

 

[Joey25]

Samuel,

A possible pre-warning of a trend move, if you like Market Profile, is a period of contracting and overlapping value areas. For example in the S&P pit session we've just had a value area on Friday which fits within Thursday's. This suggests that the locals are finding it increasingly difficult to facilitate trade.

Once the trend is in place you will see non-overlapping value areas. If you're looking for a definition of trend, this is a possibility.

Mid-distribution single prints or low-volume areas if you prefer, can also be used as evidence of trend.


Joey