This is an edited transcript of a TraderTalk workshop conducted for TM members on July 18, 2002, by TradingMarkets CEO Larry Connors. For charts, please click here.

Brice Wightman: Welcome to TraderTalk. This afternoon we are fortunate to have TradingMarkets CEO Larry Connors. As many of you know, he is the author of several books including "Street Smarts," "Trading Connors VIX Reversals," and "Investment Secrets of A Hedge Fund Manager." He also recently completed a new video, "Buy The Fear, Sell The Greed." Market volatility has increased the past few months and with it, not only the potential for increased profits, but also for increased losses. To tell you more about how you can use this increase in volatility wisely in your trading, here is Larry.

Larry Connors: Good afternoon everyone. Thanks Brice (for sucking up to me). Let's get started. Today I had planned to talk about adjusting position size in a volatile market. I will cover that but I first want to talk about the CVR signals, as they pertain to the market today. Obviously, the past two weeks, the market has gone through an extremely hard downturn. In fact, as I was thinking this out last night, I don't remember seeing a market sell off this hard without concrete news behind it.

Previous hard downturns over the past decade have been event-driven. If you look at early 1994, Greenspan was tightening interest rates. 1998 saw the long-term capital debacle and 2001 saw the WTC event. This short-term rapid downturn has not been the result of any one direct event and makes it feel at least to me, a bit different. With that said, my market timing tools, especially the CVR signals, are used to gauge when market reaches extremes and historically reverse.

We reached this extreme about a week ago, yet the selling continues. I've seen this persistency of movement occur a couple times every year (in both directions) and it looks like it is occurring again. With each selloff, we increase the likelihood of a sharp reversal. But in the meantime, it's painful. If you are uncomfortable with the risks involved trading at this time (using the CVR signals) it's best to stand aside. You will likely miss the reversal when it does occur, but in the meantime you will not deal with the drawdown if the selling continues.

I'll take questions on this and anything else we talk about, after we are completed. Please send me your questions. I'll do my best to answer as many as possible. Now let's dive into the scheduled topic, which is adjusting your position size based upon the volatility of the market. I briefly mentioned this in my Battle Plan piece this weekend and a number of members sent me questions about it, so I would like to use this opportunity to expand on this.

Over the past 90 days, the volatility of the market has approximately doubled. This means that the average daily range of most stocks has doubled vs. where it was in March. This is significant. On the negative side it means when you're wrong on your trades, you're either losing double the amount of what you were losing three months ago, and/or you're getting stopped out twice as much vs. March. On the positive side, it means when you are correct (and you're letting your profits run), you're likely making twice as much as what you were making in March. In order to smooth out these swings, I'm going to teach you how to use the VIX ($VIX | Quote | Chart | News | PowerRating) to adjust your position size, no matter what volatility is on any given day in the future.

Before I do this, I just want to mention one more thing: Volatility nearly always reverts to its mean. In a sense, you can view the mean as being gravity. In March of this year, with volatility getting lower and lower each day, Wall Street analysts were saying that we were incurring "a structural change in the marketplace and that volatility would decline for years." It's now four months later, and last night I heard on one of the financial TV channels that "this increased volatility is here to stay." None of us knows where volatility will be in the future. But we can get a pretty good gauge of it by looking over a longer-term period of time.

The best way is to take the 100-day moving average of the VIX. If you look at where the VIX has been over the last 100 days, it gives you a guideline as to what a more normal reading will be. From this normal reading, we will adjust our position size accordingly, based on the daily reading of the VIX. When the VIX is well above this 100-day moving average, we will adjust our position size downward (to adjust to this increase in volatility). When the VIX is well below the 100-day MA, we will increase our position size.

If you look at the 100-day MA of the VIX today, you will see it is in the 25% range. If the VIX is at 50% today, it would mean that volatility today is double where it was vs. the past 100 trading days.I'll now give you some general guidelines using today's volatility to adjust your position size.

Let's assume you normally trade 1000 shares of a stock. At a VIX reading of 50%, you will trade half this amount (because volatility has doubled). At 45% you will trade 600 shares. At 40% you will trade 700 shares. At 35% you will trade 800 shares. And at 30%, 900 shares.

Should the VIX drop to 20% (and the 100-day MA remains at 25%), you will trade approximately 1200 shares (all this math is approximate). Obviously, the VIX only takes into account the anticipated volatility of the stocks in the OEX, but it does give you a pretty good measurement of what overall market volatility is expected to be. Should the stock you trade have some event such as earnings, takeovers, etc., hit it, you will want to take that into account in adjusting position size. The main goal here is to look at the broader market and adjust your position size, based upon its daily volatility.

Question: Why use 25%...?

Connors: To make sure everyone understands, if you look at the 100-day MA of the VIX, it is at approximately 25%. This is the baseline we're using to adjust our position size to.

Question: Is there another way to adjust your position size, based upon the volatility of an individual stock?

Connors: Yes. Simply look at the 100-day volatility of the stock and use this as your baseline. Then look at the 6-day volatility of the stock. Use the same guidelines as above. For example, if the 6-day is double the 100-day, you want to adjust your position size by half.

Question: Do you use Kevin Haggerty's Volatility Bands to exit a trade? Can you please tell me who Kevin Haggerty is?

Connors: Oh yeah, that guy. No, I don't use his bands to exit a trade, but I do see the wisdom of using them. In fact, I have an outside researcher looking at applying the bands with the CVR signals as a possible exit/trailing stop strategy.

Question: Do you use an exponential MA or a simple MA?

Connors: I use a simple MA for my calculations.

Question: Larry you were talking about persistent selling. Have you seen a current situation with accounting issues at a time when earnings are so important?

Connors: I personally don't equate these accounting problems with the same level of seriousness that Long Term Capital created in 1998 or that September 11 brought. This is why the intensity of this sell off somewhat surprises me, but it is also why you need to have protective stops in when you trade.

Question: If you use the 6-day volatility of a stock as compared to the 100-day volatility, wouldn't that potentially have you putting in a larger position before an explosive move?

Connors: Yes. But just because something is trading at a lower reading on a 6-day than its 100-day, does not necessarily mean that the move is going to happen the next day. Each daily movement will smooth out the position size, but your point is correct and should be considered as you adjust your positions.

Question: How do you locate individual VIX readings for individual stocks?

Connors: I don't look at the VIX reading for individual stocks, but I believe you can find those numbers at www.hamzeianalytics.com

Question: Is there a length of time that you won't trade, even if you have a CVR 3 for many days?

Connors: The CVR 3 is the signal I rely upon the most. Overall, it is the best performing of the CVR signals, but it tends to be early those few times each year that we have these persistent one-way moves. With that said, I'm willing to assume the risk of being too soon and stopped out numerous times, as is occurring now, in order to be there for the many times that the signal is correct.

Question: Do you find merit in adjusting position size, based upon the number of VIX signals?

Connors: Yes, but it gets more complicated than that. I cover a lot of this in my video course (sorry to do a Landry and make this an ad) but a CVR 3 alone is more powerful, in my opinion, than a CVR 1 and 2 combined, which are weaker signals. Also, since 1999, I now use another nine CVR signals and some of those combined are more powerful than others.

The main point here is that more signals in one direction give you a higher likelihood of success. In fact, based upon our testing five or more CVR signals, no matter what their combination, has led to to profitable moves a little bit over 70% of the time within three days, over the past nine years. There is no guarantee that this will continue, but it does show that the more signals you have pointing in one direction, the better your chances of the trade moving in your direction within a few days.

Question: Aren't you, by suggesting a reduction in size if volatility increases, implying that your overall trading is losing money? If not, assuming you are a profitable trader, why not leave size alone?

Connors: I'm making no assumptions on past profitability. My goal by doing size adjustment is to be able to smooth out the returns over a longer period of time.

Question: We all want to preserve cash for the turn. Yet we are willing to take some risk to be there at the moment of the BIG reversal. Do you use call options to keep a position on for that event?

Connors: No. I have learned from experience and more importantly from Tony Saliba and his head trader Joe Corona, that long premium (i.e., long calls) is overall a losing game. Also, please remember what is going on when the market reverses and rises sharply. Volatility will implode and even though prices are moving in your favor, volatility and time are moving against you and are eating into your move. That is why I would prefer to be long the underlying market and use stops to protect myself.

Question: Lately, I find myself getting stopped out frequently, sometimes twice, where the position ultimately goes in my direction without me. How many times do you re-enter a trade (once, twice, unlimited) before you throw in the towel? Also, do you use the original entry point to enter or wait for a new signal? For instance, you have a narrow-range Trap Door entry, but get stopped out on a subsequent wide-range bar. Do you use the original entry point or a new entry point based on the wide-range bar?

Connors: You're not alone in seeing yourself getting stopped out frequently and the position reversing in your original direction. Let's talk about what the market will usually bring over a 12-month period of time. Within that time frame, you'll see periods of low volatility where it will be next to impossible to make any money because there is no range. You will see markets that move straight up (as they did in March); you will see markets that move straight down (as they have done over the past month).

But, the majority of the time the markets simply live in a state of equilibrium which means a state of gradually trending and normal swinging back and forth. Right now, we are seeing a market that has become very oversold, very volatile and very reverse driven. Within a 12-month period of time this will happen one or two times. And this one of them. Usually most traders will attempt to adjust their entire methodology in a reactive mode, based upon these extremes.

This is not the correct thing to do. Slightly adjusting for example by position size is correct. But to deviate from your overall plan because of a short-term abnormality is usually not the smartest thing to do. The thing to do is to look ahead and ask yourself what will the market likely bring over any 12-month period of time and then create strategies and money-management strategies to fit within that framework. This is a very difficult exercise but when done correctly, it allows you to live within short-term times where market behavior is abnormal, as we are seeing right now. I'm going to take a few last questions and then we will wrap this up.

Question: When you notice volatility has increased, when would you advocate adding to a position? When it moves in your favor? What are your rules here? Indicators?

Connors: I never advocate adding to a position when volatility increases. I advocate decreasing position size. Also, I do not add to winning positions. I'm looking to scale out of winning positions. And the more aggressive the move is in my favor, the more aggressive I become in looking to take profits.

Question: Your answer about options makes sense. However, the other question about constantly getting stopped out seems to be the norm among most of us. Perhaps the real folly is trying to catch the moment of the BIG reversal and not waiting for a new trend (blue arrow). I would like to trade and especially be there for the BIG move, but it seems like a zero-sum game. How do you manage to do it successfully?

Connors: This is a very good question and it gets to the heart of whether or not you should be a swing/momentum trend trader or a reversal trader. Dave Landry, Gary Kaltbaum and Tim Truebenbach are successful swing/momentum traders. Kevin Haggerty, Don Miller and myself are reversal traders.

Both styles can be extremely successful, but you can't say one is better than the other. The key is to understand how you are wired, how comfortable you are trading either style, and whether or not you have the strategies to be able to successfully trade that style. Even though Kevin, Don and I trade the same styles, we use different strategies. I believe the reason for our success has less to do with the strategies and more to do with our money management and discipline.

We each look to buy/sell market extremes, attempt to minimize risk, and we basically do the same thing, day after day after day. I can safely say that none of us makes money every day at trading like this. But the three of us have a combined 60+ years of experience (most of it Haggerty's) doing this, and it's the style that we have found the most success with. Whether or not this style works for you is 100% your decision. The only thing I will strongly urge you to do is to select one style and master it. That's the key to success in most walks of life, and it's one of the keys to success at trading.

I want to thank everyone for spending the last hour with me. If you would like any more questions answered, please email them to me directly. I'll answer you by Sunday. Thanks again.

Brice Wightman: Thanks, Larry. This chat is archived, lower left of TradersWire, just click "archives" for July 18, 2002.