Is Volatility A Four Letter Word?

The Main Ingredient

Considering the week just past, with triple digit Dow point swings almost a daily occurrence, we thought this article on volatility to be timely. The majority of investors see volatility as not only dangerous, but something to be avoided at all costs. They equate volatility with risk. But volatility and risk are two entirely different things.

To market timers, volatility is the precursor to profits. To have no volatility would be to have no profits.

In addition, to single out one period of time when volatility is causing losses, is to miss the big picture which shows that, over time, volatility is the main ingredient to making huge profits.

Controlling Profits?

Consider this example of volatility.

Let's say that you enter the market with a starting sum of $1,000 and the market enters a substantial uptrend and you are ahead by 30%. Your original $1000 is now worth $1,300.

Then the market reverses and you drop down to $1,150. Is this a reason to panic? If the trend is still intact, it is not. As trend followers, if we are still in the same trend, we may very well now move up to $1,500 or higher in short order. This is what trend following is all about... riding a trend to the end, not exiting at the first retracement.

But many traders would be devastated at dropping from $1,300 down to $1,150.

Too many market timers get upset for the wrong reasons. There is no way to control how profits are made. We can only ride the trends, as far as they will go, when they occur.

Market timers who follow trends have greater upside volatility than downside volatility because they exit losing trades quickly with small losses and stay with winning trades until the profitable trend ends.

The important thing to remember is that we stay with profitable trends, often for a long period of time.

When we start a profitable trend, we often make our profits in quick bursts of "volatility." That is why volatility is our friend, not our enemy.

We generate strong profits by correctly determining profitable trends and minimizing the cost of failed trends with quick exits.

When we have periods of sideways, non-trending markets, where there is no long term trend, we do not allow losses to accumulate.

When the market does break out into its next big trend, whether it be to the upside or to the downside, that is when we make our profits. And we do not exit the trend early. Exiting to protect profits assumes you "know" ahead of time when a trend will end.

No one knows ahead of time. So we must allow the trend to complete before we exit. That means we will catch the "majority" of the trend, when it occurs, as profits.

Huge Volatility Equals Huge Profits

Invariably, the best profits come with the highest volatility. That means as trend followers, we must react to changes in trends, stick to our guns and make all the trades.

We may have some small losses when trends fail, but when the market finally breaks out (or breaks down), we make huge gains by riding the new trend as long as it lasts, to the upside in our bullish only strategies, and in both directions (long and short) in our more aggressive strategies.

"Skeptics mistake the volatility, used by trend timing strategies to make profits, as negative. But the opposite is true."

By following a set of rules, we do not have to agonize over protecting an open profit, nor do we need to constantly change our strategies to find ways to reduce volatility.

The question is not how to reduce volatility, but how to manage it with proper risk management. This means not allowing failed trends to accumulate losses, and not exiting profitable trends early.

Skeptics

Skeptics mistake the volatility, used by trend timing strategies to make profits, as negative. But the opposite is true.

There is a big difference between volatility and risk.

Many investors see them as the same. But embracing volatility while controlling risk (cutting losses) is the key to successful trend timing.

We may see periods when profits are nonexistent for months or more. We may have several failed trends that generate small losses. But successful trend timers see these periods as the base for the next huge profitable trend.

In fact, we know extremely successful market timers who get excited when they see periods of sideways, non-trending markets as they know what comes next. The next huge trend is right around the corner! The longer the sideways market, the more profitable is the coming trend.

Unfortunately, many who do not understand the logic of market timing by trading trends are not around when the big trends occur. They are sitting at their computers trying to find a new strategy that will guarantee gains while never allowing losses.

This is an impossible goal. Losses are inevitable. But so are the gains that are achieved by trend following strategies, taking the trades, minimizing the losses when trades (trends) fail, and riding the inevitable big trends for all they are worth when we get them.