Volatility Trading Strategies: How to Trade Volatility
Volatility is often viewed as something risky and full of uncertainties. While that may be true, it is the movement in prices which keeps traders, trading.
What defines various volatility trading strategies? How can one trade in a volatile market?
In this article, we will discuss the different types of volatilities, how to trade volatility and what are some strategies that one could possibly use to trade volatility.
Sounds interesting, right? Keep reading to learn more about volatility trading strategies in the financial markets.
Table of Contents
What is Volatility?
Volatility is a measure of how the price of an asset changes with time. The more the price changes (and the more violently it does) the higher the volatility. A gradual or lack of movement in prices results in lower volatility.
Volatility is not necessarily bad, but of course, it comes with high risk. The direction of the movement is another discussion altogether, however, the movement in prices is the primary concept when it comes to trading.
Volatility is generally measured using standard deviation. It basically computes how far the price of the asset has moved from its average. A higher standard deviation means higher volatility.
Another measure of volatility, especially in fundamental investing, is beta. It measures the standard deviation of a stock relative to the standard deviation of the overall market.
Beta is like sensitivity. A value higher than 1 implies that the volatility of the stock is more than that of the market. A value less than 1 implies that the volatility of the stock is less than that of the market.
Another commonly used measure of volatility within the trading community is the average true range. It measures the range of price movements over a given period. The higher the ATR, the more volatile the prices have been over the lookback period.
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Different Types of Volatility
There are a few types of volatility when it comes to the stock markets. It is important to understand what they are and how they differ from one another.
Historical volatility is the volatility of the asset over a period of time in the past. Historical volatility can also be expressed as a ratio at times. The ratio is a comparison of the volatility (standard deviation) of an asset over a specific period relative to its long-term volatility.
Implied volatility is the expected or projected volatility of an asset. It is computed using option prices of the asset under analysis. Traders use implied volatility to make estimates on how the price of the asset might fluctuate in the future.
Intraday volatility is similar to historical volatility, but it is only for the trading day. So, it measures the volatility of the price from open to close. Intraday traders and short-term traders might find this measure of volatility useful.
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Various Volatility Trading Strategies
Trading volatility can mean different things. It could mean trading in a volatile market or taking positions in anticipation of higher future volatility.
Trading in volatile markets requires discipline and proper risk management. By risk management, we mean making sure you define your maximum loss, using features like stop losses, staying informed about the market movements via alerts, and sizing your positions correctly.
When you trade in a volatile market, there is always a risk of violent movements going against you. Now, if you trade via Contracts for Difference (CFDs), then you know that leverage adds another layer of risk.
Leverage can certainly amplify your profits. But, it can also amplify your losses. A CFD is a derivative product. So, you have to have proper risk management when you trade CFDs in a volatile market.
You also have to define the maximum loss that you are willing to take for a particular trade. Based on that loss amount, you then size your positions such that you only lose your defined maximum loss if things don’t go your way.
Trading volatility can also mean identifying passages when the volatility shrinks. You can use indicators like moving averages and Bollinger bands to identify such passages. You can then position yourself to anticipate an expansion in volatility.
Source: Admiral Markets MetaTrader 5, DAX40, Daily - Data range: from 30 March 2023 to 6 April 2023. Performed on 30 March 2023. Please note: Past performance is not a reliable indicator of future performance.
In the chart above, you can see that the DAX40 index was moving in a tight range in early April. The Bollinger Band width was also narrow indicating low volatility.
This period was then followed by a sudden breakout and an expansion in volatility. That period was then followed by a strong down move.
This is one way to trade volatility. The premise is that a period of low volatility will be followed by a period of high volatility as the compression will eventually lead to an expansion.
You can also use moving averages in a similar way. If the short, medium, and long-term moving averages come close to each other and are horizontal, it may signal that a breakout or breakdown is possible in the near term.
Volatility Trading Strategies: Conclusion
We hope you now have a good understanding of what volatility is, how it is measured, and how you can implement volatility trading strategies in your trading and risk management strategy.
If you feel ready to try out strategies to trade volatility, then go ahead and open an account with Admiral Markets.
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What is the best way to trade volatility?
Common approaches for navigating volatile markets encompass the implementation of strategies like the Volatility Straddle and the Short Straddle tactic. Essentially, these methods involve the placement of pending orders strategically above or below consolidation zones to seize opportunities arising from potential breakouts in market volatility, irrespective of whether it surges upward or plummets downward.
What are the 4 types of volatility?
The four types of volatility encompass future volatility, historical volatility, forecast volatility, and implied volatility. This answer not only identifies these categories but also outlines the process of assessing them and highlights the relationships among them.
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