Let’s take a look at some of the conditions that exist in markets currently that can support the need to have an adjustable trading model where size can be changed on the fly to minimize loss and maximize gain.
What we notice is that at points where volume started to increase, volatility usually increased in either direction (see “Something is brewing,” below). Along with the increase in volume, the price usually will fluctuate as well. We also see the direct correlation between volume, price and volatility where price and volatility move in tandem at periods of increased volume. This is consistent even in commodities, as we examine the evidence of the volume price fluctuation relationship in soybeans (see “Beans on the move,” below). Being able to capture these movements is typically what the average trading model is designed for, but with the risk protocol of changing size on the fly, the portfolio can reduce the exposure to the negative fluctuations while still remaining in tact in its overall dogma. Turning the knob up or down to increase or decrease the amount of exposure is then as simple as monitoring for the volume fluctuations that will set the new limits, which trigger the risk protocol.
The key indicators
The next step is to determine what factors will trigger turning the knob.
One method for making these determinations is to watch the overnight volume. Looking at daily volume levels is not useful because of the massive amounts of day trading. Overnight volume is a more reliable depiction of how much capital is “truly” committed to any market at any given time. Examining the average volume will help you to set parameters for your portfolio by comparing the amount of exposure your trading system takes when it is exposed to the market, and comparing it to the percentage of volume that is typically committed to the market. When these margins start to change, it could be a signal to you that you need to adjust the parameters and turn the knob.
We use the overnight open interest figures to create a base for our volume triggers. Usually we find the correlation between overnight figures and daily traded volume will have a ratio that is consistent and fluctuates in tandem. Recently it’s been roughly 1:2 overnight to daily volume. So by taking a percentage of this volume and using it as the trigger, we are able to use fluctuations in the volume to help tell us when it is time to adjust exposure. We use a 27% trigger. When volume increases 27% we begin shrinking the size of our trade. When it hits 40%, we take our trade off the table completely. On the flip side, if volume decreases by 27%, we increase our trade size by 20%, and then another 20% every 10% volume rise after 27%.