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Trading Volatility
BY Janne Muta
|July 31, 2024Accurate measurement of volatility is crucial for trading volatility as the ability to quantify it is vital in risk management. Various methods, such as variation, standard deviation, and advanced models like GARCH, along with historical and implied volatility, provide a comprehensive understanding of market behaviour. This article helps you to understand how volatility is measured and the common trading strategies used with the concept.
- Volatility reflects the degree of variation in the price of a financial instrument over time. It provides insights into the risk and uncertainty associated with asset prices and is used throughout the financial industry as one of the key measurements of risk.
- Variation refers to the fluctuations in an asset's price over a specified period. It's a straightforward measure, highlighting the range within which the asset price oscillates. However, it doesn't provide a comprehensive view of the nature of volatility's.
- Standard deviation is a more refined measure, representing the dispersion of asset prices from their average. Calculated as the square root of variance, standard deviation quantifies the extent to which individual price points deviate from the mean price. It is widely used due to its simplicity and effectiveness in providing a statistical measure of volatility.
GARCH - An advanced Model for Analysing and Trading Volatility
Advanced models for volatility measurement have been developed to capture the complexities of financial markets more accurately. One prominent model is the Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model. GARCH effectively models volatility clustering, where high-volatility periods are followed by high-volatility periods and low-volatility periods follow low-volatility periods. By using past data on returns, GARCH aims to predict future volatility, providing valuable insights for risk management and derivative pricing.
Historical vs. Implied Volatility
Historical volatility is calculated using past market prices, providing a backward-looking measure of an asset's volatility. It helps in understanding past market behaviour but may not always predict future volatility accurately.
Implied volatility, on the other hand, is forward-looking and derived from current option prices. It reflects the market's expectations of future volatility and is inferred from the prices of options using models like the Black-Scholes. Implied volatility is crucial for options traders as it influences the pricing of options contracts and helps in strategizing trades based on expected market movements.
Trading Volatility When It’s High
The VIX, often referred to as the "fear index," measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It plays a crucial role as a gauge of market sentiment and investor anxiety. When the VIX suddenly spikes, it indicates significant uncertainty and potential market turbulence.
The VIX is constructed by averaging the weighted prices of S&P 500 puts and calls over a wide range of strike prices. It provides a snapshot of expected volatility over the next 30 days, making it a valuable tool for traders and investors looking to estimate future market volatility.
Buying Stocks When VIX Peaks Above the Upper Bollinger Band
During uptrends, high VIX values can reflect panic selling, creating opportunities for astute institutional investors to purchase shares or index futures at a discount. These investors leverage the elevated VIX to identify periods when market sentiment is overly pessimistic, allowing them to buy at lower prices and potentially benefit from subsequent price recoveries.
CFD traders might consider researching strategies that aim to take advantage of these periods of institutional buying. As equity index CFDs mirror the movements in stocks and stock indices retail traders can use them to gain market exposure to them by buying CFDs. Bullish strategies after the VIX index has started to decline following a rally in the index, might help traders to exploit the opportunities created when institutional stock investors create demand in the market. This strategy however has substantial risks and requires careful monitoring of the VIX and market conditions.
The chart above shows both the S&P 500 index and the VIX index. The S&P 500 is trending higher, with the 50-day Simple Moving Average (SMA) in red and the 200-day SMA in navy, both pointing upwards. The price consistently remains above these moving averages, indicating a bullish trend.
The VIX index, depicted below the S&P 500, includes 2 standard deviation and 30-period Bollinger Bands. The VIX measures market volatility expectations. When the VIX peaks during an uptrend in the S&P 500, it can signal potential oversold conditions in stocks, prompting institutional traders to buy the dip.
A declining VIX after and the simultaneous rally in the S&P 500, suggests that institutional traders predict the market could be turning bullish. This is because VIX values reflect the market’s view of future volatility over the next 30 days. Therefore, when VIX values start to decline, it indicates a growing number of institutional investors believe the spike in downside volatility might be over and the market could be ready to move higher.
Against this hypothesis retail CFD traders should consider researching strategies that would gain by entering long positions in the S&P 500 or its constituent stocks when the VIX reverts back inside the Bollinger Bands. However, it is crucial to acknowledge that trading volatility involves significant risks. While some strategies can be profitable, they also carry the risk of substantial financial losses.
Effective risk management techniques, such as setting stop-loss orders, can help mitigate potential losses, but they do not eliminate risk entirely. Consistent risk acknowledgement is essential; trading involves the possibility of significant financial losses. Traders should study historical S&P 500 and VIX charts to determine optimal entry and exit points and plan their risk-taking professionally.
In conclusion, trading volatility requires a thorough understanding of both market trends and risk management strategies. While some strategies are potentially profitable, it is crucial to recognise the high level of risk and potential for losses involved.
Trading Volatility: Breakout trading
Breakout trading is a strategy where traders enter a position during a trend. This approach involves identifying key price levels that a Forex pair, stock, commodity, or other asset must surpass to confirm its movement in a particular direction. Traders have traditionally looked for high volume and clear price movements beyond historical resistance (in an upward breakout) or support levels (in a downward breakout) to validate the breakout. Quite often though breakouts happen without high volume so we need to pay more attention to price action itself. Once these levels are breached, it can signal either a start or continuation of the trend, prompting traders to enter the market with the expectation that the price will continue in that direction.
Consolidation breakouts during trends
Consolidation phases are periods where the price of a security moves within a bounded range, showing little net change over time. These phases are marked by a relative balance between supply and demand, often following a directional move during a trend and could be therefore temporal pauses within the trend leading to significant price movements once this balance is disrupted.
Trading Volatility: Timing the Breakout
Timing a breakout when trading volatility involves understanding how the market is likely to behave when it breaks through resistance or support levels. Traders often look for a higher low or a lower high inside the range as an indication that a breakout could be happening soon, allowing them to prepare to trade the breakout.
Breakout Trades
Breakout trades can occur during both trend reversals and uptrends. Breakouts above key resistance levels during a bullish trend reversal can lead to significant price movements when a new trend emerges. Early entry into these trends allows traders to establish a low-cost base, enabling them to add to their core position later on.
Another type of breakout trade occurs when the market pauses during an ongoing uptrend (or downtrend). As the market is already trending higher, the expected value of such breakout trades can be smaller compared to those that happen during a trend reversal process.
In the context of an uptrend, breakouts can be a signal of market strength and continuation. Traders look for consolidation periods or minor pullbacks as potential opportunities for breakout trades. These trades, while potentially offering smaller gains than those during trend reversals, can still be valuable for trading volatility long. Effective breakout trading requires careful analysis of market conditions, key resistance or support levels, and timing to maximise the benefits.
Breakout and Retest Trade
Traders may choose to enter the market only after a breakout has been confirmed by a close outside the predefined trading range. Post-breakout, it is common to analyse the market across multiple timeframes to observe if there is a retest of the breakout level. If the price retraces to this level and then rebounds, it validates the breakout. This scenario is often referred to as a breakout and retest trade, which can provide traders with a strategic position to capitalise on the anticipated upward or downward movement.
Technical Indicators for Breakout Traders
Technical indicators like Bollinger Bands and Keltner Channels are invaluable for breakout traders. These indicators help identify sideways ranges, setting the stage for subsequent breakouts. For instance, the squeeze technique, popularised by John Carter, combines these indicators to point to trading ranges and anticipate breakouts.
Bollinger Bands, which consist of a moving average and two bands with two standard deviations apart from the moving average, encapsulate price movements, indicating periods of low volatility when the bands are narrow. Keltner Channels (KC), based on the average true range (ATR), provide similar insights but are generally smoother. When Bollinger Bands contract within the Keltner Channels, it signals a squeeze, a period of low volatility.
The Squeeze
According to Carter's method, periods of low volatility often precede significant market movements. By monitoring this squeeze, traders can prepare for potential breakouts. When the price breaks out of this tight range, it is often accompanied by a spike in volatility. This breakout is the cue for traders to execute their trades, capitalising on the increased market activity.
According to Carter's method, periods of low volatility typically precede significant market movements. By monitoring these periods, known as 'the squeeze', traders can prepare for potential breakouts. When the price breaks out of this tight range, it is can be accompanied by a spike in volatility. By using this combination of indicators, traders can study past prices to confirm whether it would help them to time their entries and exits when trading volatility.
The red line (at 1,712) in this example marks the closing price of Gold on a day when the market closed above both the upper KC band and the upper Bollinger Band, indicating a market reversal. The blue line (at 1,757) indicates the daily close that moves the upper Bollinger Band above the upper KC band, marking John Carter’s preferred breakout confirmation.
Risk Management in Breakout Trading
Risk management is essential in trading to protect your capital and enhance the expected value of your trades. This is no different when trading volatility-oriented strategies such as breakout trading. Implementing a disciplined approach to risk per trade is crucial. Traders normally commit less than 1% to 2% of their account on a single trade. This limit helps maintain capital over the long term, especially important in the unpredictable realm of breakout trading.
When trading breakouts, the strategic placement of stop-loss orders is vital. Stops should not be too close to the breakout point to avoid premature exits due to normal market volatility. Instead, they should be set at a level that balances the potential for a breakout against the risk of a false breakout, thus preserving the expected value of the trade.
Adjusting position sizes according to the volatility and the distance of the stop-loss order from the entry point is another key strategy. This means if the stop-loss is further away, reducing the position size helps keep the risk consistent regardless of trade specifics. Conversely, a closer stop-loss might allow for a larger position size, still within the risk management parameters.
Conclusion
Trading volatility requires understanding and measuring market fluctuations through various methods. Volatility, reflecting price variation over time, plays a critical role in assessing financial risk and determining trading strategies. Techniques like standard deviation offer a straightforward statistical measure, while advanced models such as GARCH provide insights into future volatility by analysing past return data. Historical volatility offers a retrospective view, whereas implied volatility, derived from option prices, anticipates future market movements.
When trading volatility, observing the VIX index can guide traders on whether to go long or short in the markets. Known as the "fear index," the VIX forecasts short-term volatility through S&P 500 options. When VIX starts to contract after spiking higher buying opportunities may present themselves as the fear trade unwinds after perceived market lows. Conversely, breakout trading, another strategy discussed, focuses on entering markets when an asset surpasses predefined resistance or support levels, indicating potential trend continuation or reversal.
Understanding these mechanisms is essential for managing risks effectively in volatile markets. Traders must consider position sizing and stop-loss orders based on volatility assessments to protect their investments.
For those looking to navigate the complexities of volatile markets with robust tools and resources, registering with TIOmarkets.uk, an FCA-regulated broker with excellent customer service, is a wise move.
While research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.
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Risk warning: CFDs and Spreadbets are complex instruments and come with a high risk of losing money rapidly due to leverage. 76% of retail investor accounts lose money when trading CFDs and Spreadbets with this provider. You should consider whether you understand how CFDs and Spreadbets work and whether you can afford to take the high risk of losing your money
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Janne Muta holds an M.Sc in finance and has over 20 years experience in analysing and trading the financial markets.
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