Volatility in trading

Have you ever had problems with volatility in your trading?

vix volatility
VIX is the most known barometer for volatility in the financial world

Anyone who has traded long enough knows the capital importance of volatility, that elusive and treacherous concept that when it seems we had it dominated returns and takes revenge on us, again and again.

There are few who have not seen how their systems are tremendously affected by volatility, for better or for worse, with an increase in it or with a decrease.

But first of all let’s see a bit of what this is about volatility in trading

What is volatility?

Well, many times you hear or see in some medium that there is an increase in volatility simply because a market goes up or down, but that is not a sufficient condition.

The real condition for us to say that there is more or less volatility is when the market moves more or less nervously.

What is this about moving in a nervous way?

Well, it is like a kind of meter of the market pulsations, so that a bullish stock market of several months without frights has a quiet market and few beats and a collapse of it has a hectic market and many beats.

When nervousness increases in trading

In these cases we have greater volatility, that is, a greater movement of the price in a certain moment of time.

To see this we can better think about the two most well-known volatility cases in the world of trading and investment: the volatility of the news in the Forex and the volatility of the stock market bearish markets.

Some time ago I talked about which were the most volatile Forex pairs, but this time I will focus more on the very concept of volatility and in this case we will see the typical example of the Forex news, which serves perfectly to see when they produce those moments of greater volatility – being therefore so sought after for trading.

The best known cases in the Forex are the decisions of the interest rates of the FED, the ECB or another large central bank, or the non-agricultural payrolls of the USA.

As I mentioned already if we want to see the volatility of an instrument is as easy as using the Average True Range (ATR) indicator and it will give us the measurement of the size of the movements for the period we choose.

Volatility in Forex news

For example, the following chart is of 5-minute EURUSD bars, on a day with news that produced volatility.

forex volatility
volatility increases

In this case we have the ATR of 14 periods of 5 minutes, which measures the average of the last 70 minutes.

As we see, the periods before the news the market was very quiet with bars with the price moving an average of 3 or 4 pips every five minutes, a “misery” in the Forex market.

Later, when the event came out the volatility went up as the price began to move strongly until it reached 12 pips of average per 5 minutes.

As we can see, volatility increased by 400%.

Well, speaking of the pipos this will seem little but when you see the issue in percentage terms or ratio, being the volatility 4 times higher in the news than before these, you will understand that concept is really important and can affect our trading.

Volatility in the stock markets

The case of volatility in the stock market is usually quite classic, bull markets with less volatility and bears with much more volatility as people start negotiating with fear and the price changes are much higher for the same amount of time.

This happens again and again without exception being one of the basic rules to take into account if we want to make stock trading.

The thing is similar to the news of the Forex but here we see more from a more long-term point of view, not intraday.

The leading indicator in this case is the VIX which is always mentioned by the stock channels and is followed by the large institutional investors.

The fact is that bull markets are often accompanied by good news and a climate of safety that makes investors buy and sell quietly, without too much pressure, hence the low volatility of them.

investing volatility
Low and high volatility

In the following case of the S & P500 we can see how the volatility was around $ 13 per day (using the ATR again), which would be about 0.5 of the index price on those dates.

Well, when the correction arrived, the nervousness and the “fear of the end of the world” began.

In this scenario that is repeated again and again in the stock market, in some with more force than in others, obviously, we see how prices move very fast and the average happens to be 50 dollars per day, which is practically 4 times more than the volatility of the bull market; Interestingly the same increase we found when the market gets nervous in the Forex.

This is for the main indices, but the thing changes for the stocks where we have from the known penny stocks with a gigantic volatility to the stock dinosaurs – like General Electric – that barely move.

For example, some cases of high volatility can be found in popular shares of the Netflix-like moment, with a daily movement of around 3% without the need for bear markets.

Well, these are the two cases where volatility affects traders the most since they are the most followed markets in the world, or at least not long ago.

A third market has arrived to compete for the immense market of traders: cryptocurrencies.

Volatility of cryptocurrencies

These markets are, at least until 2018, the most volatile in the world.

If we realize the indices move from the order of 0.5% to 2% depending on the volatility (more if it is a large bear market) of the moment.

With the great drop in the price of cryptocurrencies in 2018, Bitcoin has reached a 3% volatility, having reached even 10% in the dates of most movement of those markets at the beginning of the year.

If we compare this 3% with the typical 0.5% of Wall Street, we see that we have instruments that are much more volatile than the stock market, so we should take this into account. The brokers, of course, have it, because many of them reflect it in their spread.

About this spread a little more later.

Other cryptocurrencies such as Ripple or NEO have even more volatility, of the order of 5 to 10% daily.

Volatility in commodities, bonds and other instruments

Raw materials have always had a lot of volatility but the truth is that this is not always the case.

They have their particular cycles and that fame comes from the golden age of futures trading back in the 70s of the last century when the cycle of interest rates made the markets of raw materials were the main protagonists.

That was a golden age of trading in the United States when many of today’s technical indicators were created.

Although here we can mix the concepts of volatility and trend, because the truth is that oil always tends to be quite volatile even when there is no definite trend, and the “volatility” of the 70s took place along with a great trend.

In the oil market we can expect a volatility of between 2 and 3% as usual, rising to 6% or more if we have large recessions with price collapses or simply large movements in the price of oil, such as the falls of 2008 and the 2014

The volatility of gold, however, is usually lower, around 1% normally in “quiet” markets and rising to 2 or 3% in very hectic markets.

volatility in gold may rise in both bull and bear markets

The daily volatility of the Forex is similar to that of gold, perhaps a little less, according to the pair.

Volatility in Forex and bonds

For example, the EURUSD usually has a volatility of 0.75%, which rises to 2 or more at times of great uncertainty in the market.

The other asset is closely related to Forex, since it depends on national credit policies, bonds, which may be why it is the market that least interests retail traders, but it does not stop being of interest for professional traders or institutional

In this market, and at least until today in the most advanced markets, such as the United States, Japan or Germany, the volatility has been quite low, of the order of 0.40% daily in moments of calm and of 1% in moments of risk and uncertainty.

As we see, every instrument is a particular beast with its greater or lesser volatility, which means that trading in those markets has to take into account this concept.

Typical daily volatility Normal Moments of uncertainty
S&P 500 (índex) 0,5% 2% a 9%(en casos extremos como 2008)
Netflix (stocks) 3% 6 a 10%
Bitcoin 3% 10%
Ripple 7% 20%
Oil 2% 6 a 8%
Gold 1% 2 a 3%
EURUSD 0.75% 2%

Keep in mind that this volatility will tend to change over time, especially as some assets consolidate, such as cryptocurrencies, for example.

Volatility, spread and trading strategies

Trading in the EURUSD is not the same as in Ripple, with a volatility 7 or 8 times higher.

The stop of 30 pips in the EURUSD, assuming it is 0.25% of the price of the asset, would have to have an equivalent of about 2% stop in Ripple, if at least we want to apply a trading strategy similar to the that we apply in the Forex pair.

That is, if we have a trading strategy we will have to take into account the different volatilities between the different assets in such a way that it is “harmonized” between said pairs.

Now, the thing is not as simple as it seems.

Why?

Because we have the real problem when applying a trading strategy in the same asset, and see how changes in volatility destroy that strategy.

How many times have I seen a great strategy for low volatility ends up being destroyed as volatility increases very strongly?

What to do then?

The solution is not easy at all.

It is not because one thing is to see how assets evolve after the trade and another thing is to go trading at the moment, for which sometimes you realize a little late and you are not able to enter the required adjustments to save the strategy.

A possible solution would be to try not to operate with a certain strategy when volatility changes.

For example, I have a strategy that suits me with a volatility of 1% in the price of the GBPJPY.

However, when there is disruption in the market and this asset reaches 2% or more of volatility, my strategy starts to turn to water.

Therefore, a solution would be to try to stop operating when volatility reaches 1.9%, for example.

But what am I saying?

Is not volatility supposed to be good for trading?

Yes, but to a certain extent.

What is really good for trading is that there is a market in a certain direction, that is, in a trend.

That is much more important than volatility.

Believe me; you will not want to trade when the volatility is as high as in October 2008 in the global stock markets, because no matter how much volatility you have there, the market nervousness is so great that it is almost impossible to overcome the various problems that we are going to find there.

It is not that in a situation like this one cannot make effective trading, but the difficulty increases dramatically.

In those cases, experience says that it is better to wait until the thing calms down and enter a more “calm” market, such as March-April 2009.

However, there are also strategies that go better in markets of extreme volatility and bad in those of low volatility.

As for the spread, it is a topic that brokers have a lot in mind, and not only apply a lower spread in the more liquid assets but also in the less volatile ones.

If an asset has liquidity but volatility increases, brokers are forced to increase the spread dramatically.

You see, when there is uncertainty in the markets, the brokers worry, and a lot.

Therefore, it is always good to see what spread and what volatility there is in each moment in each broker and in each asset, two important measures that we should take into account in our trading.

This you cannot ignore.

Volatility strategies with stock options?

One of the most commented strategies in trading channels is the possibility of buying options to “take advantage” of volatility.

This would be the strategy known as “volatility cone” or “straddle”.

It is a very simple strategy, in reality, which consists of buying a call and a put at the same exercise price and expecting the market to move a lot.

Here, the premium we are paying for these options will be of vital importance, since it will depend not only on whether the market moves or not, but on the price that we have paid.

But here I will comment again on the misleading concept of volatility here.

We can make this strategy when the market has fallen hard and expect the price to continue to fall or to rebound very strongly.

It is in those moments when such a strategy would make sense.

What can happen is that the market rises very strong and a week later it falls again, with extreme volatility, but with the price returning to the initial exercise price.

In that case we would have lost the straddle even with a market with extreme volatility.

That’s why I said before that volatility is one thing and the direction is another.

Now, it is also true that this strategy needs volatility to be carried out, which does not mean that we can lose the bet even though the market behaves in a volatile way too.

As always, trading and its complications.

What is certain is that you have the strategy that you have always going to have to take into account the volatility of that asset, because it depends on your survival as a trader.

Greetings and good trading

Original article: La importancia de la volatilidad en el trading

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