Experienced traders know that volatility can come at any point, in any part of the interconnected markets we trade. Smooth trending markets or rangebound markets can also be interrupted by sharp shocks and unwanted volatility.
Volatility is the statistical tendency of a market to rise or fall sharply within a certain period of time. It is measured by standard deviations – meaning how much a price deviates from what is expected, which is generally its mean.
When volatility increases, we should see wide ranges in price, high volumes and more trading in one direction – for instance, few buy orders when the market is tanking, few sell orders when the market is ramping. At the same time, traders can be less willing to hold positions as they realise prices can change dramatically — turning winners into losers.
Deeper analysis of market volatility suggests that there is a higher probability of a falling market when volatility is high, with lower volatility being more common in rising markets.
There are many factors which cause volatility in markets, such as surprise central bank announcements, company news and unexpected earnings results. However, what links all of these together is that reactions are caused by psychological forces which every trader undergoes during the course of their trading day.
At market peaks, traders feel content about their returns and believe the favourable market environment will stay in place for an indefinite period. Trading is seemingly the best job in the world, as it is easy to manage risk and pick winners. In other words, complacency has set in and any red flags are dismissed.
The flip side is the emotional stages of a downtrend in the market. A state of denial can quickly turn into anxiety. This loss of confidence sees plans and strategies changed or even forgotten as fear sets in, before the dreaded sense of despair turns into capitulation.
This last period is where traders reach their breaking point. The pain is only relieved by pressing the sell button and there is often an inability to think rationally. This stage is the classic ‘be fearful when others are greedy, and greedy when others are fearful’ point, a well-known phrase uttered by legendary investor Warren Buffet. The strong hands are accumulating at this point, while the weak hands are still in liquidation mode.
Fear and greed are the two key ingredients that feed volatility. They are the real foundations of price action when volatility increases and can occur on any time frame. Scalpers through to day traders and swing traders all experience this.
The emotional rollercoaster of trading and investing is one every trader must endeavour to smooth out.
As we know, volatility measures the overall price fluctuations over a certain time. There are numerous ways traders can measure these movements. One of the most well-known is the Volatility or VIX index.
The VIX measures the market’s expectation of 30-day forward-looking volatility in the S&P 500 index. Calculated by prices in options, a higher VIX reading signals higher stock market volatility, while low readings mark periods of lower volatility. In simple terms — when the VIX rises, the S&P 500 will fall which means it should be a good time to buy stocks.
A reading below 12 is said to be low, whereas a level above 20 is deemed to be elevated. For the record, the all-time intraday high is 89.5 which occurred in 2008. Comparing the actual VIX levels to those that might be expected can be helpful in identifying whether the VIX is “high” or “low”. It can also provide clearer indications of what the market is predicting about future realised volatility.
There are other similar indices in bond and currency markets implied by option pricing, which are also very useful in measuring volatility.
The VIX is included in another widely followed barometer known as the Fear & Greed Index. Here, CNN examines seven different factors to score investor sentiment, by taking an equal-weighted average of each of them.
The index is measured on a scale of zero to 100 – extreme fear to extreme greed – with a reading of 50 deemed as neutral. The index has become a bellwether for when fear is at its peak.
History shows that this indicator can be a reliable guide to turning points in the stock markets. For example, the collapse of Lehman Brothers during the GFC in September 2008 saw the index sink to a low of 12. Three years later, the gauge had hit 90 as global stock markets rallied hard after the final round of the Fed’s asset purchase programme – QE4.
If we want to dig deeper into more specific price fluctuations regarding a particular market, it is worth looking at implied and realised volatility. The former represents the current market pricing based on its expectation for movement over a certain period of time. This forward-looking figure allows a trader to calculate how volatile the market will be going forward; for instance, the implied move and range for a currency pair with a significant degree of confidence. This is extremely useful for calculating stop distances and position size.
This is the actual movement in prices that takes place over a defined historical period. Technical analysis indicators like the Average True Range (ATR) and Bollinger Bands can help us to define this. The ATR shows how much an asset moves on average during a given time frame. A falling ATR signals narrow price ranges, therefore volatility is decreasing. A rising ATR points to growing volatility.
Bollinger Bands depict rising and falling volatility. They act like dynamic support and resistance levels and can signal overbought or oversold conditions. The bands widen when volatility increases, and narrow when volatility falls.
Trading is a risky business – essentially, you are managing your risk constantly throughout the day on each position you hold, or calculating the potential risk on new positions. Let’s look at five principles a trader should employ when volatility increases:
1Manage risk - understand the risk on every trade you do. If you know the expected returns on each trade by knowing all the possible entries and exits, you are forced to systematically visualise and compare your trades. A trader should constantly respect certainty over risk. In times of increased volatility, this will generally mean reducing your leverage and position size.
2Order types - always use a stop loss, as you will know the exact amount of risk you are willing to take on the trade before you enter it. Remember, “it’s not the money you make that makes you a winning trader; it’s the money that you don’t lose.” If you are using moving averages to set levels, consider using long-term averages to reduce the chances of a price spike triggering your order when volatility is high.
You could also consider using limit orders which potentially reduce your risk by buying slightly above the market price. In effect, you are making the market rise a little more, which means you are buying into the trend rather than against it.
Take profit limit orders are important as well – successful traders know the upside potential on their trades and what price they will exit when they are in the green. This eliminates emotional trading, which is more important than limiting your upside – you can always re-enter your trade if you get new signals.
3Stick to your plan – you should have a robust, well-defined strategy which you have tested in all market conditions. This should mean you do not jump into volatile markets, erratically ignoring your pre-defined rules. A knowledgeable trader should also have guidelines around fundamental risk events such as central bank meetings and earnings releases, which historically are high volatility events.
4Emotional control - volatile markets can influence traders to quickly abandon their plans and patience. Never let wishful thinking – known as confirmation bias – skew your thinking. You must have the discipline to accept the evidence and not react impulsively. Similarly, traders often look at recent returns when making snap decisions – recency bias — causing them to potentially chase performance.
5Educate yourself - no matter how experienced a trader may be, there is always room for improvement. This means doing your homework thoroughly, when the going is difficult as well as when trading seems easy. Reviewing your processes is also ongoing and non-negotiable.
Trading is especially risky during volatile times
A CFD is a financial derivative based on the underlying market which enables you to open positions with a high degree of leverage. You buy or sell contracts which represent an amount per point in that market.
As you do not take ownership of the underlying asset, trading CFDs means you can deal on both rising and falling markets. They give you the opportunity to go long or short on a broad range of instruments including stocks, indices, forex and commodities.
When volatility increases, you can use CFDs to diversify some of your positions. In currencies, this might involve betting for the US dollar in one position and against it in another. In stocks, you could spread your risk across sectors, market cap or geographic region.
In this situation, you might not only use full positions with these trades, but take on even larger exposure. Such a strategy may offset profits, as well as risk. It may also add complexities to your trading that may not be welcome. That said, diversification done well should result in capital preservation in heightened times of volatility.
Trading CFDs can be especially effective when buying and holding shares in overseas markets. In effect, you have currency exposure so using FX CFDs can reduce the impact of currency fluctuations on your physical portfolio.
In the same way, volatile stock markets can potentially be hedged using CFDs on indices. On the other hand, if you are expecting a sharp downturn, then you could take a short-term position in a safe-haven asset which, in theory, should retain its value if the market takes a turn for the worse. Gold is a classic example of a safe-haven asset.
There are a variety of strategies to use, including trading assets that move in a different direction to your existing positions or positions that directly offset your existing one. Whichever way you choose, CFDs are a great way to neutralise market exposure when volatility is high, as you need to be able to take positions in both directions.
Average True Range (ATR) - the average trading range of the market for a certain period of time.
Bollinger Bands - volatility bands placed above and below a moving average, set using standard deviations.
Contract for Difference - a leveraged derivative which allows you to trade both long and short. You exchange the difference between the opening and closing price of a contract.
Implied volatility - the market’s forecast of a likely movement in an asset’s price. Often used to set prices for options contracts.
Realised volatility - gauges the changes of an underlying asset by measuring price changes over a certain period of time, sometimes known as historical volatility.
Standard deviation - a statistical measure showing how widely prices are dispersed from their average. A narrow trading range will mean low volatility.
VIX - a gauge of the 30-day expected volatility in the S&P 500, sometimes known as the ‘fear’ gauge. A high reading implies a risky, volatile market.
Volatility - a statistical measure indicating how much and how quickly the value of an asset can change around the mean price over a certain time. High volatility normally means higher risk as prices are less predictable.