Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

DISCRETION, VOLATILITY, AND PRICE SHOCKS

Just as there are no objective criteria for what constitutes a paradigm shift, neither are there any for price shock events. Instead, I have found it useful to develop a hybrid discretionary-objective overlay for my mechanical trading systems that is based on highly aberrant increases in volatility. Whether the rest of the investment community decides that a particular increase in volatility was a price shock or not is irrelevant to me. Instead, the key is employing a robust criterion that forces me to reduce my exposure to market environments that could endanger my trading career.

Although there are certainly arbitrary numerical thresholds—such as a 50 percent increase in one-year historical volatility levels—that could trigger a reduction of volumetric exposure, because volatility exhibits both trending and cyclical tendencies, I hesitate to limit my definition of an aberrant increase in volatility to any static numerical threshold. Instead, I argue that a more robust solution to the issue of determining volatility thresholds includes the overlaying of a discretionary filter onto the objective, percentage-based threshold of a 50 percent increase in one-year historical volatility levels.

For example, if a 45 percent increase in one-year historical volatility is the direct result of an ultra-short-term, unsustainable headline-driven event (e.g., the capture of Saddam Hussein), then scaling back of volumetric exposure is probably unwarranted. ...