What is Volatility Trading? 

Volatility is a measure of how much the returns of a security or market index fluctuate over time. It’s often determined by standard deviation or variance. The rule is simple: the higher the volatility, the higher the investment risk. 

In financial markets, volatility is typically associated with large price swings (up or down). When a stock market fluctuates by more than 1% for a sustained period, it’s referred to as a “volatile market.” 

The volatility of any financial asset is a crucial factor in determining the prices of options contracts. 

Understanding Volatility 

Volatility typically refers to the amount of risk or uncertainty associated with changes in a financial asset’s value. 

High Volatility: Indicates that the security’s price can move sharply up or down within a short period. 

Low Volatility: Suggests that the security’s price is stable and doesn’t experience significant movements; instead, it tends to remain steady. 

Leveraging Volatility in Trading 

By understanding volatility, you can build smart trading strategies that enhance your profit opportunities. This can be done in several ways: 

• Trading Volatile Assets: Seeking out assets that show significant price movements. 

• Monitoring Volatility: Using it as a criterion for selecting appropriate investments. 

• Utilizing Technical Indicators: Employing analytical tools based on volatility. 

• Investing in Stable Assets: Focusing on less volatile options depending on your goals. 

Volatility is a highly important indicator for both short-term traders (like day traders and swing traders) who focus on daily and weekly price changes. 

So, how can you trade based on volatility? 

This concept can be applied across different markets and timeframes. In this blog, we’ll explore volatility trading strategies applied to stocks, forex, and commodities. 

Measuring Volatility 

To calculate volatility, we primarily rely on two statistics: variance and standard deviation (which is the square root of variance). 

Since volatility expresses changes over a specific period, its value is calculated by multiplying the standard deviation by the square root of the number of periods within the time horizon, using the following formula: 

Volatility = σ√T  

Where: 

σ = Standard deviation of returns 

T = Number of periods within the time horizon (the period over which volatility is measured). 

How We Measure Volatility in Stocks? (Illustrative Example) 

To simplify, let’s assume we have the closing prices of a specific stock over 10 months, ranging from one dollar to ten dollars (Month 1: $1, Month 2: $2, and so on). 

To calculate variance, we start with these essential steps: 

• Calculate the Arithmetic Mean: Sum all monthly prices:  

(1+2+3+…+10=55dollars)  

Then divide the sum by the number of months (which is 10 in this case).  

The arithmetic mean (or average price) is $5.50 (55/10). 

• Find the Deviations: (Between each value and the mean)  

Subtract the mean ($5.50) from each monthly price.  

Example: 10−5.50=4.50, then 9−5.50=3.50, and so on until 1−5.50=−4.50.  

(Note: Negative values are acceptable in this step).  

Using a spreadsheet is preferable to facilitate these calculations. 

• Square Each Deviation: Multiply each deviation by itself to eliminate negative signs. 

• Sum the Squared Deviations: Add up all the squared results. In our example, the sum of these squares is 82.5. 

• Calculate the Variance: Divide the sum of squared deviations ($82.5) by the number of values (10).  

The resulting variance is 82.5/10=8.25 dollars. 

Calculating and Interpreting Standard Deviation 

To get the standard deviation, we simply take the square root of the variance. In our example, the result was: 

2.87 dollars. 

What Does Standard Deviation Mean?  

It’s a measure of risk, showing how prices are distributed around their average. It gives traders an idea of how likely the price is to deviate from the average. 

To understand the distribution (under a normal price distribution): 

• Approximately 68% of prices fall within one standard deviation. 

• 95% of prices fall within two standard deviations. 

• 99.7% of prices fall within three standard deviations. 

Importance of Standard Deviation  

In our illustrative example (values from $1 to $10), the data was not normally distributed (bell curve); instead, it was uniform. Therefore, the percentages (68%-95%-99.7%) do not apply directly. 

Why do traders still use it then?  

Despite this, standard deviation is a very common tool for traders. The reason is that actual price return data in reality often closely approximates a normal distribution (bell curve shape), unlike the simplified example we used. 

Volatility Trading Strategies 

Daily Volatile Stocks for Trading  

Volatile stocks are key to day trading. Large price movements accompanied by high trading volume make it easier for traders to enter and exit positions. 

A volatile stock is one whose value changes significantly daily, with these changes sometimes exceeding 5%. Some stocks exhibit this volatility consistently, while others show large movements only on specific days. Traders can seek out either type. 

A simple strategy for daily volatile stock trading:  

On a five-minute chart, wait for a short-term trend (which can be identified with a ten-period moving average). Then look for consolidation, which is three price candles moving sideways. Enter the trade when the price breaks out of this consolidation in the direction of the original trend. This is a simple and relatively effective strategy for highly volatile stocks. 

Applying Volatility Trading: The Case of American Airlines Stock 

During the first half of 2020, American Airlines stock showed daily volatility exceeding 6%, with a predominant upward trend. 

To exploit this volatility:  

A trader can set a stop-loss at $0.02 outside the consolidation range and set a target profit equal to twice the risk size (the difference between the entry price and the stop-loss). 

The chart above (continuous downward trend) shows:  

In a continuous downward trend and with a consolidation area at a bottom (e.g., $12.975), a short sell can be entered as soon as the price breaks the consolidation level by about $0.01, i.e., at $12.965. 

Defining Risk and Target in a Short Sell  

Let’s assume in our example that the upper limit of the consolidation area is $13.035. The stop-loss is set at $13.055. 

Risk: $0.09 per share ($13.055 – $12.965) 

Target: $0.18 per share, i.e., at a price of $12.785. 

Important Note: This strategy (day trading) is suitable for any stock with an upward trend. However, it is more effective in volatile stocks, as large price movements increase the chances of reaching the target. 

Using a Trailing Stop-Loss Strategy  

For more flexible trading, a trailing stop-loss can be adopted, such as a twenty-period moving average. This strategy allows the trader to follow strong trends and indicates an exit point when the price touches the moving average line. 

It’s notable that an increase in the volatility of a major market index (like the S&P 500) is often accompanied by an increase in the volatility of its constituent individual stocks. 

Exploiting Volatility Breakouts 

A volatility breakout occurs when the price of an asset surpasses support and resistance levels on a chart, signaling a new trend. 

To measure these breakouts, we use technical indicators like the Average True Range (ATR). This indicator monitors the average price movement of an asset per candlestick. 

A significant rise in the ATR indicator is a strong warning signal for traders of a potential trading opportunity, as it indicates strong price movement currently occurring and the likelihood of a breakout. Trading here is known as a ”volatility breakout trading” strategy. 

Volatility Breakout Trading: Gold Example (Using ATR) 

The one-hour gold price chart shows multiple opportunities for volatility breakouts. To identify them, a 20-period Simple Moving Average (SMA 20) was added to the ATR indicator. 

Entry Conditions:  

A trade is considered probable when the ATR indicator crosses above the Simple Moving Average. To increase the signal’s effectiveness, the price must also have crossed above or below recent swing highs or lows. This ensures filtering out false signals resulting from a rising ATR without real price movement. 

The chart illustrates four trade entry setups. To turn them into a strategy, exit points must be clearly defined: 

Defining Stop-Loss: 

Buy Trades: Place the stop-loss order below the most recent low swing (swing low). 

Sell Trades: Place the stop-loss above a recent high swing (swing high). 

It’s preferable to use the 20-period Simple Moving Average (SMA 20) as an exit point. This indicator is popular and provides accurate exit points in strong trending markets. 

When the price touches the moving average, it often signifies the beginning of a trend reversal or a slowdown in momentum. This is a strong signal to consider closing the trade. 

How to Trade in Low Volatility Markets 

Trading highly volatile markets isn’t everyone’s preferred option; the majority of long-term investors prefer market stability. However, day traders can even profit from low volatility by acting as a Market Maker. This involves placing buy and sell orders to contribute to liquidity, with profits coming from the spread between the bid and ask prices during the day. 

Example of How to Profit from Low Volatility?  

Suppose a stock is priced at $0.01, showing no significant price fluctuations. If there are buyers at $0.03 and sellers at $0.035, a trader can place a buy order at $0.03 and a sell order at $0.035. If both trades are executed, they will realize a 16.6% profit without any change in the stock’s price. 

This illustrates how a stock, even if not volatile in quantity, is volatile in a high percentage. Every $0.005 movement represents a significant jump. 

Types of Volatility 

Implied Volatility (Market Expectations)  

Implied Volatility (IV), or expected volatility, is one of the most important tools for options traders. This measure allows them to estimate the extent of future market fluctuations. 

Function and Limitations:  

While implied volatility helps estimate probabilities, it is not a definite forecast. It does not predict future market movement with scientific accuracy. 

Difference from Historical Volatility:  

Unlike Historical Volatility (HV) (which is based on the past), implied volatility derives from the option price itself and reflects market expectations about future volatility. This means that past performance cannot be relied upon; instead, traders must assess the option’s future potential. 

Historical Volatility (A Look at the Past)  

Historical Volatility (HV), or statistical volatility, measures how much an asset’s price has fluctuated based on its past movements over specific time periods. This measure is less common than implied volatility because it does not predict the future. 

Understanding its Signals: 

High Historical Volatility: Indicates that the asset’s price is moving faster than usual, which may suggest a potential upcoming change. 

Low Historical Volatility: Reflects the dissipation of uncertainty and a return to price stability. 

It can be calculated based on daily changes or changes between closing prices. Historical volatility is usually measured over periods ranging from 10 to 180 trading days, depending on the purpose of using options. 

Common Volatility Indicators 

To analyze market volatility, traders rely on several key indicators: 

• Average True Range (ATR): This indicator measures the average range of price movement for each time period (candlestick). 

• Historical Volatility (HV) vs. Implied Volatility (IV): 

• Historical Volatility (HV): Measures past price movement (shown on the chart below) and doesn’t look to the future. 

• Implied Volatility (IV): Derived from option prices and predicts future volatility. Example: Low historical volatility might be followed by a sharp rise in implied volatility before an important announcement, such as a central bank’s interest rate decision. 

• Relative Volatility Index (RVI): Analyzes the trend of volatility itself (the bottom indicator on the chart). 

Above 50: Indicates an upward trend in volatility. 

Below 50: Indicates a downward trend in volatility.  

Usage: Useful for confirming entry signals: 

• Strong buy signal if RVI is above 50. 

• Strong sell signal if it’s below 50.  

It should not be used as an independent indicator. It must be used in conjunction with other strategies. 

• CBOE VIX Index (“Fear Index”): This index measures stock market volatility over 30 days and is used as a gauge of market risk. It’s calculated based on the average prices of S&P 500 index options. 

Leveraging Technology in Quantitative Volatility Trading 

What is Quantitative Volatility Trading?  

Quantitative Volatility Trading is a technique that relies on computer programs and algorithms to profit from changes in market volatility. 

Benefits of Software:  

This technique enables the application of strategies over much shorter timeframes and the execution of far more trades than a human trader can manage. 

How it Works:  

A computer can execute ultra-fast trades (in fractions of a second), allowing it to perform hundreds or thousands of trades daily, aiming to make small profits from each trade by applying a variety of the strategies we previously discussed. 

In conclusion, volatility can be leveraged in diverse trading strategies, whether in high-volatility markets (like volatile stocks in day trading and volatility breakout strategies) or even in low-volatility markets through the role of a market maker. Whether you’re looking for opportunities in large movements or prefer stability, always remember that practice and continuous learning are key to success in the ever-changing world of trading. 

Are you ready to apply and leverage the power of volatility in your upcoming trades? Head to  naqdi  now and benefit from expert insights and diverse educational tools.