Volatility Reflexivity & Mean

Reversion
Mark Whistler
ON TARGET
Over the Next Hour We Will Touch
On...
Volatility Volatility Reflexivity & Market Psychology
Reflexivity
Indicator Failure | Information Failure
Market Understanding Failure

Four Types of Volatility Defined

Volatility Market Volatility | Price Volatility | Period-Mean
Defined Volatility | Probability Volatility

Probability Volatility
Volatility Expansion = Trending
Probability
Volatility Volatility Compression = Lateral
Trading

Mean Reversion
Trading Mean Two Types of Mean Reversion
Reversion
Identifying Opportunity
To Unlock the Mystery)
● We must first be willing to think critically (with an open mind) about
why what we’ve been told is reliable- Is truly reliable.
● We must check the math.
● We must not accept vague terms like “overbought and oversold.”
● We must be willing to consider the possibility that 95% of the
information, media, analysts and economists present is wrong.

We Must Then Be Willing to Deconstruct

Everything We Know...
● We must be willing to put in the time-
● We must have a thick skin-
● We must be willing to consider the fact that the information
believed to be true, may have been
bad from the start...

We Must Be Willing to be
Patient While Putting the
Pieces Back Together..
First Piece of the Puzzle to Unlock)
What is Volatility Reflexivity?
• The imperfect understanding of
markets and trading by individuals,
media, and professionals creates
volatility...
• "Volatility" is really opportunity and can
be spotted through generalizations.

Volatility
Reflexivity
 George Soros and
Reflexivity
• "Human understanding is often incoherent
and always incomplete."

• "People base their actions not on reality but

on their view of the world. And the two are not
identical."

• "Therefore, outcomes are liable to diverge

from people’s expectations."

• "Events that have thinking participants cannot

be understood without taking that divergence
into account."
Influenced by Karl Popper
Popper's Model of Analytical Science

Initial Final
Generalizations
Conditions Conditions
 The Problem
Initial
Conditions with Popper's
Model
Confirm
Outcome The Theory of
Generalizations

Generalization
must be
TRUE
 Overbought
and
Oversold

Investopeida.com
Defines
Overbought as...

1. An asset that has experienced sharp upward movements over a very short period of
time is often deemed to be overbought. Determining the degree in which an asset is
overbought is very subjective and can differ between investors.

2. Technicians use indicators such as the relative strength index, the stochastic
oscillator or the money flow index to identify securities that are becoming
overbought. An overbought security is the opposite of one that is oversold.1
Influenced by Karl Popper
Popper's Model of Analytical Science

For Example...

Stochastics Selloff
Market Rally Pending
Overbought
Initial Final
Generalizations
Conditions Conditions
Reversal

What if the Final Conditions

are not met though?
Why Generalizations are so Harmful!
To Link Our
Initial Conditions Must Have Vehicle Expectations to the
AKA Expectations "Generalization" Outcome...

When Trying to Figure Out

What Went Wrong?

• When we depend on generalizations, we can never

question the generalization that was the vehicle
linking our expectations to the outcome... Otherwise,
we would see the GENERALIZATION was the
problem from the start...
• So we look at everything else that could have been
the problem... Except the problem itself...
• The Generalization...
How We Most Often Perceive
Markets and Trading...

Fact Fact Fact = Outcome

We commonly believe information, trading opportunity,

technical events, trends, etc... Move in a logical,
sequential flow...

For example, "When Stochastics trade above 80, the

currency must be overbought, and thus, a reversal is
pending..."

But this type of thinking fails to consider how higher

prices might change some traders opinion to: Higher
prices mean the currency is breaking out to a new range,
or the beginning of a trend...
Theory of Reflexivity
Expectations Fact

= Outcome
Understanding Perceptions

Fact
"The actual course of events is likely to differ from the
participants’ expectations and the divergence can be
taken as an indication of the participants’ bias."
The Alchemy of Finance | George Soros | Page 41
Imperfect Thinking (Perceptions) of
Market Participants
How Participants Are Influenced By and also Impact Markets

Cognitive Function
• Participants Perceptions Are
Dependent on the Situation
• Example: One may not consider
taking a position long, unless an
upward trend were in place.

Passive Function
• The situation is influenced by
the participants perceptions...
• Example: Higher prices may
lead participants to perceive a
"breakout" and thus, take
positions long... Which, in-turn,
drives prices even higher...
Volatility Reflexivity
We must take another step beyond Soros' Theory
of Reflexivity, to remain clear, balanced, and
profitable during stressful short-term trading...
 Step 1
Unlinking Our Expectations
from the Outcome

• We must cognizant of our own thinking and

emotions, constantly asking ourselves if we have
possibly linked our expectations to the outcome...

• If we have, we must ask ourselves if our

perception of reality has become skewed, or
biased, based on the fact that we are expectant
of a particular outcome...

• If we find we have linked our expectations to an

outcome, we must identify the Generalization (the
vehicle), which may be causing the problem...
 Step 2
Separate Facts from
Perceptions of Broader
Market...

• Ask ourselves if price is influencing perceptions,

or perceptions influencing price?

• Ask ourselves if perceptions are being influenced

by facts, or perceptions?

• Step back from the situation and attempt to

"weight" the situation in-terms of "expectations
aligned", or "uncertainty persists" within markets.
 Step 3
Be Fully Prepared to
Change Our Minds, Should
the Situation Warrant Such...

• If we have linked a perception (expectation) to an

outcome, and we have identified such... We must
ask why we have linked our perception to the
outcome?

• We must then ask what other possible information

we might be (consciously or unconsciously)
ignoring, to keep our expectations cheerfully linked
to the outcome....

• Be prepared to close our position (winner or loser)

should the facts | perceptions show our expectant
outcome is likely flawed...
 Analyze Facts Analyze Analyze Expectations
Fundamentals, News,
Perceptions Ask Where Facts and
Politics and Technicals Both Our Own and That of Perceptions May be Linking
Other Participants Expectations to an Outcome

Are
Perceptions
Biased or
Is Price Influencing Warranted?
Perceptions, or are
Perceptions Influencing
Price?
Is There Really
Opportunity or
Risk Right
Now?
Perceptions Versus Price
Perceptions Influencing Price
• Can be both retail and institutions
• Most often though, perceptions influencing price
are institutions seeing risk, or potential future
value gain or loss, and are taking action

Price Influencing
Perceptions
• Can be both retail and institutions
• Most often though, technical signals
are a derivative of price influencing
perceptions... Meaning, retail traders
are reacting to price movements...
 Another Piece of the Puzzle
What is Volatility?
• As currently discussed, defined,
and thought of by media,
traders, and educators...
Volatility is a generalized term
covering erratic price action,
risk within returns, and/or fear
within markets...

• There are really four types of volatility...

• Most important thought, volatility is
probability...
Volatility for Active Traders
The four types of volatility that affect common trading and
markets are:

1. Market Volatility
2. Price Volatility
3. Mean-Period Volatility
4. Probability Volatility

Volatility is
Not an
"all-encompassing"
word!
Market Volatility
"The CBOE Volatility Index® (VIX®) is a key measure of
market expectations of near-term volatility conveyed by
S&P 500 stock index option prices. Since its introduction in
1993, VIX has been considered by many to be the world's
premier barometer of investor sentiment and market
volatility."

Price Volatility
Price volatility is a both a cause of, and
derivative of market volatility, probability
volatility and mean-period volatility. While
price volatility is really nothing more than
an extra description of the total low-to-
high range of prices in any given period
measured, the label is required to
separate "price action" from the other
three volatility descriptions...
Mean-Period Volatility
Mean period volatility is simply the paradigm where shorter-
term distributions will likely show greater volatility than that
of their longer-term counterparts. In addition, the shorter the
period measured, the greater the volatility of the same
mean measured. For example: A 50-period mean on 15-
minute chart will show greater volatility than a 50-period
mean on a 4-hour chart.

Probability Volatility
• Total probability of potential Price
Volatility, Mean-Period Volatility at any
given moment.
• Influences and influenced by Market
Volatility
• Significant "real time" tool in helping us
identify opportunity or risk within
markets and trading...
Probability Volatility • Expansion and
Compression of
Standard Deviations

• Is a leading Indicator

• Specifically informs us of
"total possible
probability" at any given
moment...
Standard Deviations
• Measurement of
Probability
• Expand and Compress
• Identify When Trending
is About to Begin, or
Lateral Trading is in
Effect...
Standard Deviations
• Shape of distribution does not matter...
• Distribution (just like the mean) is not static, rather, it is dynamic like prices
and time...
• Probability remains intact, because the distribution moves AND standard
deviations (volatility bands) expand and contract...
Fatal Flaw of Assuming Static
Distribution...
Why Standard Deviations Expand and
Compress, and What the Occurrence Means!
Identifying Trending Versus Lateral Trading
Action...
To Trade With the Trend or Mean
Reversion?
• Price action mean • "Reload Mean
reversion occurs
when random
Reversion" Occurs
when Institutions Allow
Prices to Fade Back to
Three Types
volatility strikes after
a news
announcement...
Mean in Order to Obtain
a Better Fill of Mean
Reversion
Price Action
Reload
Reversion

• Uncertainty, or Fair Value

Mean Reversion Occurs in
Lateral Markets and can
be Spotted Through
Volatility Compressing...

Volatility
Compression
Mean Reversion
Mean Reversion Opportunity
Probability Volatility Compression
Equals Mean Reversion Opportunity!
Don't Fear Lateral "Chop"
Anymore! It's Really Just
Volatility Compressing and is
Filled with Mean Reversion
Opportunity!
Questions?
Thank
You!

Volatility Reflexivity & Mean

Reversion
Mark Whistler