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Feature
 Volatility:
Friend or Foe?
by
D.R. Barton
I�ve had some interesting discussions with folks over the past several weeks on several polarizing topics. For example, we�ve discussed whether subsidies are a good thing. In general, they�re great for those being subsidized and not so hot for those paying the subsidies. Of course, the greater good can be achieved by such government subsidies, but they can also cause undesirable effects. There are definitely two sides to the argument!
In the markets, one of the topics that produces a broad range of responses is volatility. We�ve seen marked increases in volatility across almost all trading instruments in the last six months.
Is this a good or bad thing?
One thing is fairly certain�higher levels of volatility are most likely to stick with us for quite a while.
For some investors and traders, dealing with this increased level of volatility is tough. For long term traders and some swing traders, it�s a burr under the saddle. For others, it�s an outright menace.
Many long term investors, especially in the institutional world, equate volatility with risk. This is fairly easy to understand; higher volatility means greater variability of results. And higher variability looks like less certainty or more risk.
For swing traders, higher volatility can mean that it�s much more difficult to stay in positions. Stops are hit much more frequently and profitable positions evaporate in moments. Shorter time frames are needed, and reward-to-risk ratios tighten.
Ah, but for some, the increased volatility is the fuel that fires the engine. Intraday traders see volatility as opportunity. Wider daily ranges mean that there are more and better chances to find profitable trades.
The Best Traders� Market
I have said many times that I believe e-mini index trading is the most potent and efficient way that a trader can employ their trading capital today, especially when using the right tools, strategies and mental approach. To understand this great trading instrument, let�s look at a little background.
In the futures trading world, e-mini index futures have grown into quite a phenomenon. They have experienced growth unlike any other instrument, and for good reason. E-mini contracts were started by the Chicago Mercantile Exchange (CME) in 1998 with the S&P 500 e-mini. Currently, it is worth 1/5 of the larger, pit traded S&P futures contract.
However, for reasons we�ll discuss next, the S&P e-mini has far eclipsed its older, higher-valued sibling. As of the first quarter of 2007, the S&P e-mini was trading 4.5 times the dollar volume of the large S&P 500 contract. Today, the e-mini trades more than 10 times the volume of the pit traded contract! There are many reasons for its popularity:
- The e-mini contract is traded electronically on a platform called Globex.
- Trades are executed instantaneously and are basically error-free, especially relative to the pit traded contracts that may require several levels of human interaction before orders are executed.
- The smaller size and therefore reduced margin requirements of the e-mini contracts allow a high degree of retail participation.
The immense popularity of the S&P e-mini has led to
a number of other equity indexes trading electronically in the e-mini size. The most popular among traders are the Nasdaq Composites, Dow Industrial, the up and coming Midcap 400 and the Russell 2000. E-mini trading has also spread to commodities (e.g., gold and oil), bonds and currencies.
Let�s look at why traders love these instruments so much. After we review these attributes, we�ll talk about what�s happening now in the world of e-mini trading.
Leverage. One of the biggest advantages for e-mini trading is the high amount of leverage they offer. And for day traders, this leverage is increased further. Let�s look at the actual leverage available: the S&P e-mini trade unit is $50 times the S&P 500 Stock Index. Currently, that calculation looks like this: $50 x 830 = $41,500. The margin to control $42k worth of stock is around $6k, giving you leverage of about 7:1 on your money. However, the day trading margins drop significantly with $1,000 margins still available and some reputable firms offer $500 margins. At these rates, you can increase your intraday margin to greater than 80:1!
But leverage is a double-edged sword that definitely cuts both ways. While such leverage allows for large returns on very little money, it can also mean that you can lose large amounts as well. In next week�s article, we�ll cover tools that allow us to use this leverage in a big way, while protecting our downside.
Liquidity. Liquidity is usually thought of in terms of volume, and it is this characteristic that gives us the ability to get in out of trades quickly and at a preferable price. E-mini index trading gives us exceptional liquidity and great fills with little slippage. These attributes are necessary to allow us to take advantage of the available leverage.
Scalability. Certain types of trading can only be used on a small scale and cannot be translated to larger volumes as success occurs and larger position sizes are required. But e-mini index trading in general and S&P e-mini trading in particular are highly
scalable. Getting virtually no-slippage fills on 200 S&P e-mini contracts is an extreme advantage.
Round-the-clock liquidity. The S&P e-mini has liquidity 23.5 hours a day, which gives another advantage�the effect of overnight gaps is greatly reduced. You can keep a stop in the market if you�re doing a swing trade and have your protection kick in at a time when your IBM stock is still sleeping.
The Best Market Keeps Getting Better
As I mentioned above, higher volatility equates to greater opportunity for day traders. And today�s markets are giving us unprecedented levels of volatility. Since June of 2008, we have had ZERO days where the Average True Range (ATR) for the 24 hour S&P 500 e-mini contract has been below 20 points! Combined with the leverage available in the e-mini markets, we have a place where every trader can compete with a level playing field and find multiple opportunities every day.
Next week, we�ll look at some specific tools and strategies that top e-mini traders are using today to take profits in these markets.
Please note that I�ll be teaching a new, cutting edge workshop on
e-mini index trading in Raleigh on March 14�16. Next week I�ll tell you about my good friend and awesome market maven who will be joining us for the workshop. It�s a learning experience you don�t want to miss!
About
D.R. Barton: A passion for the systematic
approach to the markets and lifelong love of teaching and
learning have propelled D.R. Barton, Jr. to the top of the
investment and trading arena. He is a regularly
featured guest on both Report
on Business TV, and
WTOP News Radio in Washington, D.C., and has been a guest
on Bloomberg Radio. His
articles have appeared on SmartMoney.com and Financial
Advisor magazine. You may contact D.R. at
�drbarton� at �iitm.com�.
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