I must admit… I’m a Boy Scouts of America dropout.
But I did learn a few things before I called it quits.
The art of fire-making was one of them. And that skill has served me well through life… particularly on the first weekend camping excursion that my wife and I went on about 11 years ago.
“BAM! There’s your campfire baby! One match!”
(We had only been dating about two months at the time… so I’m sure this man-in-charge move is what sealed the deal).
One of the fundamental principles of fire-making is this: Your fire needs to breathe… it needs oxygen. Without it, you can spark a hundred tinder bundles, but you’ll never get that roaring, flame-throwing combustion that keeps you cozy in a cold campground.
As a financial market trader… I think of volatility as the oxygen-like fuel that feeds a systematic strategy’s “profit engine.”
Without volatility… a strategy’s profit engine can’t do the work… and it doesn’t leave much money to be made.
So, while passive, buy-and-hold investors have been conditioned to see volatility as a bad thing… active investors see it as a good thing. And instead of fighting it, we learn how to harness volatility expansion and use it to our advantage.
I mentioned last week in Ahead of the Curve that volatility is mean-reverting. This means that volatility expands for some time, then it contracts for some time. It’s cyclical… moving up and down with a reasonable degree of predictability.
A visual will help…
Here’s a chart of the S&P 500 (in blue). With it is a volatility indicator, which simply measures whether volatility has expanded (red) or contracted (green) over the month prior. Take a look…
As you can see, periods of volatility expansion follow ones of volatility contraction, and vice versa. It has a cyclical nature… which provides a very lucrative opportunity to make money. Here’s why…
Short-term trading systems — like my newly launched Max Profit Alert — thrive when volatility is expanding.
And since a phase of volatility expansion always follows a phase of volatility contraction… this indicator works well as a “timing” tool.
The idea is pretty simple…
On the other hand, after a period of volatility expansion (i.e. turns red), an investor should be more cautious about entering new positions. Instead, these are good times to close a trade and take your profits.
But you don’t have to take my word for it that it works this way. I’ll prove it to you…
I’ve just run some data-driven studies on the algorithm I developed for my Max Profit Alert service. I call it the “Alpha Profit Code.”
The algorithm, by itself, works extremely well. I’ve been running “live” tests on it for well over a year now. But I had a hunch that it could be improved… simply by incorporating the volatility indicator above.
So I tested this hypothesis…
Basically, I created one additional “rule” for the Alpha Profit Code, only allowing it to recommend a new trade if volatility is in a contraction phase. The computer code looks something like this:
IF VolatilityIndicator is less than 0 then allow New Trades.
IF VolatilityIndicator is greater than 0 then DO NOT allow New Trades.
Pretty simple, right?
Well, the result of this one additional rule was quite powerful!
Relative to the “baseline” strategy, the new strategy is more selective… more accurate… more profitable… and less risky. That means fewer total trades, a higher win-rate, a higher average profit per trade, and a smaller maximum drawdown — all good things!
Specifically, the average profit per trade with the volatility expansion rule was 38% greater than without it. The maximum drawdown was less than half.
That’s a powerful improvement on an already profitable strategy. And it certainly debunks the idea that volatility is a bad thing.
Read my lips: Volatility is a GREAT thing… if you know how to use it!
Of course, I realize you might not get as fired up about this number-crunching style of investment research as I do! And if that’s the case, that’s perfectly fine.
But you can still profit from it!
I’ve been showing novice investors how to make short-term, high-probability plays in the markets for years now — ZERO technical expertise required, on your part.
It all started with Cycle 9 Alert, which we began offering to a select group of readers back in November of 2012.
And now we’ve opened the doors to my newest investment research service — Max Profit Alert.