Chuck LeBeau's System Traders Club
BULLETIN Vol. 1 Number 8 Oct. 8, 1998

SPECIAL INTERIM BULLETIN

DEALING WITH EXCESSIVE VOLATILITY:

The recent volatility in the stocks, bonds, and currencies have created opportunities and problems for traders. Brief periods of excessive volatility are nothing new and we all need to have a high volatility contingency plan that allows us to deal with these conditions in a rational and objective manner.

You never want to just skip trades arbitrarily. This is a bad idea and can quickly become a costly habit. I have a rule of thumb that I try to apply in cases of high volatility that helps me to decide if I should enter a trade in a high volatility situation. I should warn you that this rule sometimes saves me money and it sometimes costs me big profitable trades. The primary benefit of the rule is that it is
objective and disciplined. The rule keeps me from just guessing and agonizing over what to do in situations where the volatility is obviously extreme. The rule has some inherent logic that helps me to quantify "extreme" volatility on a system by system and market by market basis.

The rule is that if the recent daily range is greater than the money management stop you are using, you don't do the trade. The logic is that our money management stops should be outside the range of what normally happens in one day. To have stops closer than that is to be inside the "noise level" where you can get randomly stopped out for no good reason. Once the market settles down to where the range between the high and low is less than the amount of your stop you could then enter the trade and safely place your stop.

Now let me give you a specific example. We just took a quick but big loss on a Yen trade today and it is now set up for a new trade tomorrow. The range over the last day or two, as we all know, has been far beyond normal, several times more than our protective stop loss. The trade for tomorrow should be skipped because of the volatility rule described above. If you like, the trade can be entered at a later date when the average true range is less than our stop.

This volatility rule applies to all systems and markets. It does not come into play very often and it is not something we just made up for the Yen. I have found it to be a valuable rule that I have used for years to limit my exposure in times of excessive volatility.

Please keep in mind that high volatility is an opportunity for unusually large profits as well as losses and if you skip a big winner you will certainly regret it. For those with more than adequate capital an alternative solution is to reduce the position size and arbitrarily change the money management stop to a much bigger number on a temporary basis. If you can afford losses of this size this might be a better solution because you would avoid being stopped out needlessly and you would still be able to participate in the big winners. Based on past experience I would say that as a minimum a stop of about two recent average true ranges would be required. Obviously this would be a huge dollar amount to be risking in Yen or S&Ps right now.


Good luck and good trading.

Chuck