Malcolm Graham
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Malcolm Graham in Analytics & more!,

How to trade the S&P during volatile periods

What is the best way to trade a market that is sporadic, directionless, and risky?

One of my favorite approaches incorporates the use of cost-basis improvement techniques to achieve superior results while mitigating volatility. Arguably, the methodology I prefer also enhances volatility given the underlying instruments, so my approach mitigates volatility in already volatile instruments.

Specifically, I use the double ETFs ProShares Ultra S&P500 SSO, +0.91% and ProShares UltraShort S&P500 SDS, -0.81% for the S&P 500 in conjunction with my market analysis to trade. The objective is quite simple: if my analysis tells me the market is likely to head higher on a near-term or midterm basis, I want to be in SSO, but if the market analysis that I have conducted suggests that the market is likely to fall on a near-term or midterm basis instead, I want to be in SDS.

I think the above paragraph can be construed by everyone as being oversimplified. It is easy to say get long if the market is going higher and get short if the market is going lower, but we all know it is not usually as easy as that. Instead, there is usually volatility, backing-and-filling, concerning news events, analyst comments, and our stupid human emotions that get in the way of making it easy.

The process that I use of incorporating cost-basis improvement techniques makes this a little easier. We cannot expect it to be foolproof, so as we continued to discuss this technique, please make sure that the objective is understood. The objective is to make it less volatile while maintaining our position.

Let's assume, for example, that the market is at a level of support from which it is likely to increase. Given that observation, we would want to be long the market, so SSO is a clear option.

Let's also assume that the market begins to increase a little bit, but then begins to experience volatility, not unlike we have seen recently, warranting some action, but not the disposal of our overall opinion about direction.

Let's go one step further and also assume that the support line that triggered our position was a midterm support level, and the market has since increased to a near-term level of resistance. There is a hierarchy in technical analysis and the midterm charts are always more important than the near-term charts in my opinion, but that doesn't mean the near-term resistance levels should be ignored.

In fact, near-term resistance can be very actionable. In this example, if we established our position near a level of midterm support, when the market was at that near-term resistance, but it is not yet at midterm resistance, of course, we could then take steps to improve cost basis and validate those steps using the technical patterns that exist.

The objective would not be to relinquish our position completely (our target would be midterm resistance in this example), but it does involve selling our position. These double ETFs move quickly, and small moves in the market can result in relatively large moves, so it doesn't take much to improve cost basis. The price of SSO at the time I write this, for example, is 131.50. It is not unusual for this ETF to move .40 or .50 within half an hour or less, but if we diligently watch resistance levels and mitigate our position based on tests of both the near-term and midterm resistance levels accordingly, we could take advantage of that relative volatility and embrace it.

If the market was testing a near-term resistance level when the price of SSO was 131.50, we could, reasonably, exit the position near that level with the intention of buying it back at a lower level.

We're not looking for a home run here, that is not the objective of improving cost basis, but instead the objective is to improve cost basis a little bit at a time, sometimes we could do this day after day, so if we sold near 131.50 and bought back near 131.10 it would serve our purpose quite well. The cost-basis improvement would only be about 30 basis points, which is not mind-boggling, but it can add up significantly over time and it can significantly improve performance while reducing associated volatility. If we did this for four days within a one-month time span, for example, we would have a 1.2% improvement.

This process is a trading strategy, it is not for buy-and-hold investors, but it is a very effective method of maintaining an overall bias while mitigating volatility and improving cost basis over time.

In addition, for more aggressive investors, you could also switch from one side to the other, from long to short for example, and double the effectiveness of your cost basis improvement technique by not only reducing your cost basis from the double-long position, but also by realizing positive results from the double short. In this more aggressive example, not only would you sell near the near-term resistance level, but also engage a short position using SDS accordingly.

This process is not something that is easy for most investors to do but it is something that traders can use effectively. I use it all the time.

http://www.marketwatch.com/story/how-to-trade-the-...