Thursday, April 22, 2010

Predictable Volatility... Really ?

It is intriguing to find that one of the most common ways in which expert advisor makers try to exploit the market for a profit is the use of "predictable volatility". This concept is founded in the fact that the market is supposed to move "more" during some ours and "less" during other hours of the day, effectively making a person able to predict when the market moves the most and when it moves the least. This is true to a certain extent since it is not a mistery that - for example - the EUR/USD tends to move much more when the US and EU trading sessions overlap. This is natural and it is a consequence of the way in which the world is setup, it is only obvious that a currency pair will move more when the countries where the currencies are most traded are "online" at the same time. However, there is a long road from "predictable volatility" to the exploitation of a market inefficiency something which I intend to explain within the remainder of this post. I will try to argument why "predicting" volatility does not imply profits and why exploitations of an inefficiency based on this principle will most likely be short lasting.

Notice how I always put some quotes around the word predicting. The fact is that even though a person can effectively say -with a high like hood of being correct- that the cross between the US and EU sessions will have a higher volatility than the previous Asian session the person cannot tell you exactly by how much or if this volatility will be directional or non directional. The fact is that this person has exactly the same data as all the other market players who all know that the market moves more around this time (for the EUR/USD as an example) and less around the Assian session. So what advantage does knowing this give a person against other market players ? Basically none, since the information is already there and it is already priced into market action.

Then we have a problem related and additional to the above which is the move from the theoretical to the practical field. How would you exploit a time of predictable volatility ? It does not seem to be straightfoward as the technique used would depend greatly on the directionality and character of the actual market movements. For example, you may try to exploit a "predictable" surge in volatility on the EUR/USD by placing a breakout trigger above and below the current price level before the market reaches that predicted time. However, if volatility is non-directional you will find that you enter a trade towards the wrong side when price starts to whipsaw around your previous price level. In the end you'll see that the market is efficient to this information and does not allow anyone to take profit from this in the long term as the directionality of the increase in volatility is actually not predictable with a statistically significant probability. A mathematical expectancy analysis of a breakout strategy in the beginning of the US/EU session overlap reveals this to be the exact case.

Then the other strategy is to exploit areas where volatility is "predictably low" in order to use scalping techniques. I wrote a post concerning this before, particularly about EUR/CHF and EUR/GBP scalpers which exploit this principle. The main problem here is that the inefficiencies of periods of low volatility are based exactly on this fact. When you trade during a period of low volatility you are increasing volatility by your intervention. If enough people do this or if you introduce enough volume you'll make the market efficient to your own trading strategy. In fact, this is why most of this EUR/CHF scalpers started to fail or be much less profitable, due to the fact that the inefficiencies on this time frames were widely acknowledged and their "edge" was lost. The fact is that low volatility inefficiencies are what people would call "non-tradable" since trading them actually makes them less profitable, a tactic which would -as many people fear- die if trading volume increases significantly.

In the end I think that this "predictable volatility" tactics actually have no solid basis as the information they are based on is fundamentally known to all new and proffesional traders out there- besides - any mechanical trading system developed on the basis of "predicted volatility" at any given time is bound to be unprofitable with time as the volume changes due to the trading of this actual inefficiency. Looking at volatility patterns during this "predictable" times during the past few years reveals very important changes in the way they happen, their directionality and their start and end, pointing to the fact that long term exploitation of market inefficiencies based on them is not possible. Think about these trading tactics as glasses of water, once you drink the water, your done.

If you would like to learn more about automated trading and what I have learned regarding their design, construction and programming with sound strategies please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

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