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Five Ways to Deal With the Changing Environment image

While the world waits to hear what Janet Yellen has to say about Fed policy this morning, it is probably a good time to expand on the idea that the character of the stock market has changed and look at what investors can do about it.

Last week, it was suggested that moves in the market - especially on days when something big occurs - have become exaggerated due to the proliferation of algorithmic trading. "When a bunch of trend-following algos start chasing each other's tail, the end result is an increase in the size of daily moves," was one of the key points made.

As we explained, the key here is to understand that daily price action is becoming more and more volatile (and perhaps even a bit artificial) - in both directions. Once the algos get on a roll, they often just keep going until the closing bell rings. Then traders come in the next day and start all over again.

And to reiterate, we're not complaining about the computers here. Algo-driven trading is fine, fair, and completely legal. No, the key point being made today is that investors need to recognize that the game is changing.

What Can Investors Do?

In talking to investors (professional and otherwise), it is obvious that this topic is important. Most folks recognize that the game is moving faster and farther than ever before. However, very few have any ideas about how to adapt their strategies to the changing environment.

So today, we will discuss five different ideas to help combat an environment where intraday volatility is increasing and the moves have become exaggerated.

So without further ado, let's get to it.

Adjust Your Time Frame

The first thing that an investor can do is to adjust the time frame you are working with. For example, if you trade intraday, you simply must realize that unless you can trade at the speed of light, you are at a competitive disadvantage. Don't for a moment think that you can keep up with the algos after news, earnings, or a Fed announcement. So, in short, stop trying.

In addition, it is probably a good idea to lengthen your time frame. Don't feel like you have to go home flat. It's okay to hold a position overnight. Remember, the intraday moves are often exaggerated. As such, you may need to hold positions longer in order to stay in tune with a move. The ride may be bumpier, but the trend can indeed be your best friend at times.

Trade in Steps

The next idea is to stop being a "plunger" and move in and out of positions in steps. In other words, you don't need to put an entire position on all at once. You can do it in stages.

This is especially true during times when the market is making a big, algo-induced move. So, if your strategy says to buy and the market is really movin' on up, it might be a good idea to put on a partial position to start with. Then you can add to that position on any downside volatility that comes along.

Discover Mean Reversion

Mean reversion strategies assume that when a stock or index gets too far away from its mean, it will eventually move back to its normal trend. This is where overbought/oversold are often used. For example, if a stock is moving up nicely and then it starts to "go parabolic" it might be a good idea to take some profits and wait for the stock to pull back a bit.

This concept is also referred to as swing trading. While it may sound overly simplistic, the key here is to buy low and sell higher. Thus, when stocks become oversold and are nearing a support zone, swing traders will buy the dip and look to sell the position in the next few days or weeks when the ultimate recovery/rebound occurs.

Granted, such a strategy does not work worth a darn in a strongly trending market. Remember, when the bulls get on a roll such as they did in 2013, the trick is to jump onboard and enjoy the ride. However, it is also important to recognize that all trends end at some point. And once a strong uptrend has ended, implementing a mean reversion or swing trading strategy can add serious value to your approach.

Stop Staring At Charts

Back in the day, trendlines, moving averages, and support/resistance zones were drawn with a pencil and a ruler. However, today every trader on the planet has access to fancy charts and more indicators than you can shake a stick at. As such, it might pay to recall that "something everybody already knows isn't worth knowing."

The point is that everybody in the game is looking at the same key levels on the charts. And this is one reason why an intraday move will accelerate once an important technical level is breached. You see the move, your colleague sees the move, and rest assured, the algos see the move as well.

Because of this, it is probably a good idea to put less emphasis on the key levels that everyone is watching. Don't base your entire trade on a support zone giving way. Because if and when it does, the day may turn into a repeat of February 3rd in a hurry.

Take Your Foot Off the Gas

Particularly when the environment gets violent, such as it has since mid-January, it might be a good idea to play the game more conservatively. Trade less. Trade smaller. And maybe even hold some cash when the VIX starts jumping. If you ever find yourself dazed and confused, just take a break. There is no shame in simply admitting that the action doesn't make sense.

Remember, there is no law that states you must be in there trading each and every day. And perhaps most importantly, it is always a good idea to sell to the sleeping point. The bottom line is life is too short to lose sleep over a trade or a position in your portfolio.

Finally, the real key to this meandering missive this morning is that it is important to recognize that market environments are constantly changing. The trick is to be able to identify the type of environment and to know what tools to use to best deal with whatever Ms. Market is serving up at the time.

So, the times, they are a changin'. The question you have to ask yourself is what are you doing about it?

At our shop, we're adding managers and diversifying across strategies and methodologies so that we can hopefully keep pace with the changing environment. We probably won't get it exactly right, but we are definitely making some adjustments.

Positions in stocks mentioned: none


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