Introduction to Volatility
As the markets have been extremely volatile over the past few years, expert traders have profited from this volatility while limiting their inherent risks and exposures at the same time. But if you’re not a professional day-trader, hedge-fund manager, or proprietary trader, the methodologies used in this advanced trading strategy may be somewhat daunting. Let’s begin with a basic understanding of what volatility is.
The Definition of Volatility
In finance terms, volatility is a measure of the variation of the price of a financial instrument, and it can be defined by either: Historic volatility or Implied volatility.
Historic volatility is derived from time series of past market prices, whereas, Implied volatility is derived from the market price of a market-traded instrument, particularly derivatives like options.
Volatility allows us to determine whether a financial instrument is cheap or expensive by comparing the Implied volatility to the Historical volatility.
Volatility’s Meaning in Trading Terms
In trading terms, volatility means that we will be able to assess whether a market is cheap or expensive, and therefore, whether or not it warrants a particular buy or sell trade based on this.
The markets generally will have wide swings between high and the low points which are driven by certain measures.
One of the most common measures for volatility is the Volatility Index or (VIX). The VIX is often referred to as the ‘Fear Index’, which essentially is a gauge of the market’s sentiment or expectations.
The VIX, along with the SPY (S&P 500) is one of the most significant market indices that many professional traders use. It is significant for a practical reason, as it puts a firm value to Implied volatility.
In trading terms, Implied volatility is the essential part of the pricing of derivatives such as options. In terms of the VIX, it is a measure of Implied volatility of S&P500 Index options.
The common practice is that the VIX calculates the expected move of the S&P500 Index over the next 30 day period (annualized).
Currently (25th June 2013) the VIX is trading at 20.11%. So, as an example, the way to work out the potential range of the S&P 500 over the next 30 day period is:
20.11% divided by the square root of 12 (12 being 12 months annualized).
20.11% / √ 12
20.11% / 3.464 = 5.8%
Based on this calculation you could expect that the S&P500 Index would move by approximately 5.8% within the next 30 days.
Even though this might be the expectation over the next 30 days, it does not help when positions we are trading in Stocks or Indices start to move by more that 2-3 times their average daily ranges.
And as traders, seeing movements of up to 2-3% per day on a financial instrument being traded, can be somewhat of a concerning thing.
But it is important to understand that the movement could be due to the volatility of the markets as a whole, and such volatility is not necessarily based on direction of the markets. It could just be determined by price moves within that particular day.
Why Does Volatility Occur?
There are a number of theories as to why market volatility occurs, but they all generally stem from news, events, fear or uncertainty. These factors cause people (and markets) to behave irrationally when there is no certainty as to what lies ahead.
Therefore, if markets go down in a dramatic way then volatility can become very extreme. When this happens traders will usually look at the VIX Index for potential directional or timing queues.
But it is also important to remember, that the VIX is a mathematical formula that is applicable mainly to an options style trade, and as such, it may not be 100% relevant to each and every trade.
Furthermore, although a trade may not initially be affected by volatility, it is still possible that the movement when/if it does come could be so severe that it could literally wipe out a position.
Looking at the S&P500 (Chart 1) and the VIX (Chart 2) below, if we compare between market corrections we will notice that every time the VIX spikes above 20 we tend to see a decent market correction/movement down in the S&P500.
Why Should Traders Pay Attention?
Depending on what type of trader you are it is important to understand that volatility comes and goes, and eventually volatility will mean-revert and come back down. The problem most traders face is what to do during volatility. The expression: “The markets can stay irrational longer than you can stay solvent” certainly rings true.
Therefore you shouldn’t place trades that are too large too soon, as this may have the effect of stop losses being triggered prematurely, or fills on stops being worse than anticipated and losing more money than expected.
Surviving During Volatile Times
First and foremost you need to develop a strategy that accommodates your own goals, time horizons, and most importantly your risk tolerance. Amateur traders usually say they know what their risk tolerance is, but once market volatility appears they usually have no organized way of dealing with it.
One of the best counter-measures to make it through volatile times is to ensure your portfolio is well diversified, as this way your risk is adequately spread around and not put in one basket.
Diversification is best done across different asset classes such as Stocks, Stock Indices, Forex, Commodities and Options in order to soften any price swings.
As already mentioned, it is imperative to avoid large positions and over exposures in a single instrument, as this way we limit the risk of one particular ‘bad’ trade turning into an excessively large loss.
Having said that, it is quite possible to do very well from trading volatility. If handled carefully, and if the above points are adhered to, then good gains can be made from overextensions or rapid moves during volatility.
To make money in any market you need to have a professional edge, and volatility trading strategies certainly are a useful addition to a trader’s portfolio, so long as the strategy is effectively utilised. At Trade View Investments we comprehensively cover volatility trading and how to use it as part of your overall trading strategy in our In-House and Online Systems Building Workshops.