Stocks & Commodities V. 31:2 (10-13): The Volatility (Regime) Switch Indicator by Ron McEwan

Shifting Gears

The Volatility (Regime) Switch Indicator by Ron McEwan

Here’s how you can construct a simple Excel spreadsheet for the volatility switch indicator.

Which trading strategy should you use? This is a dilemma that most traders face, especially when the market changes its trend, which seems to be the norm these days. You may be dealing with a market that is reversing direction every few days, and without warning, the market breaks out into a lengthy trend that catches you off-guard. By the time you can adapt to the new mode, you could have sustained a considerable drawdown.

Regime switching

Years ago, some very clever individuals came up with methods to cope with abrupt and dramatic changes. This concept was labeled “regime switching,” a method for adapting a trading strategy when the market changes from a trending mode to a mean-reverting one.

Many regime switching algorithms are available today. They generally involve complex mathematical algorithms. At the heart of most of the regime switching strategies is a measure of volatility. The direction of volatility, rising or falling, as well as the level of volatility, will give a good indication of whether the market is in a trending or mean reversion mode. As a basic first step, this article will explain how to construct a simple volatility switch indicator to assist in determining whether your security of choice is trending or in a mean reversion mode.

To start, you should have at least one year’s worth of data for your security. Three to five years (or more) will give you a more reliable picture of how the security reacts over time to change in volatility.