Managing volatility, like uncertainty, is part and parcel of being a successful trader. It is in managing uncertainty and volatility in a manner that fits a trader’s style and risk appetite that the junction of acceptable individual risk and reward is reached.
But what’s the difference between uncertainty and volatility, and how can traders manage a spike in volatility? Indeed, how can traders anticipate an increase in volatility? These are questions any trader needs to ask themselves, and have an answer for, so they know how to follow one of commandments of trading: trade the market in front of you.
Put simply uncertainty in trading begins with the realisation that when a trade is instituted the outcome is unknown.
World-renowned trading coach Dr Alexander Elder explains a trade is instituted at the far righthand side of the trading screen but the outcome is not known until some point in the future when time has moved the market, its prices and a trader’s entry level back toward the centre of the screen.
Only then can you know with any “certainty” if a trade has been successful.
As a result, uncertainty is the very thing that traders must embrace in order to be successful. That’s because when buying a share, selling a currency, buy commodity, or undertaking whatever the trader’s new position might be, there is no guarantee of success, or of profit. To repeat, the outcome is unknown at the time the trade is undertaken.
So, while the rest of the population might feel uncomfortable with uncertainty traders must become comfortable with it.
That’s not to say that traders are reckless or foolhardy. Nothing could be further from the truth.
Any good trader who has been plying their trade for a reasonable period of time will tell you it’s their risk management which is key to their success. Trade entry protocols are important. But it’s the amount of capital they risk on each trade and the associated position sizing, stop-losses or take profits which drive their equity curve higher.
But volatility within a trader’s positions handled via risk management protocols is very different to the overall volatility observed in the market. Traders need to identify changes in the volatility regime in the markets they trade and act accordingly.
In contrast to the unknowns associated with the uncertainty, volatility has a reliably grounded mathematical explanation and meaning.
Put simply volatility is a statistical measure of the dispersion of returns for any given asset price, stock, bond, currency, commodity, index, even economic or other market data. Inherent in that definition is that in measuring the dispersion – the width or spread – of price changes, we get a sense of how vicious the movements can be.
For example, while it might be usual for the Australian dollar to trade in a 70 point (0.7 cent) range each day on average, the actual volatility can move from 30 points up to 150/200 points – 2 whole cents – on extremely volatile days.
That’s important because it means that positions instituted when the market was calmer might suddenly be too big and thus put more of a trader’s account balance at risk than they wanted. Likewise stop-losses might prove ineffective, take profits likewise. In short, increased volatility will usually accompany changed risk settings, even if a trader’s process remains the same.
Why volatility rises
Knowing when volatility is going to spike is almost impossible.
But Hyman Minsky famously showed in his Financial Instability Hypothesis that periods of acute stability in economies, in our case markets, can sow the seeds for a spike in volatility because of the complacency that stability brings to trader’s positions and the risks taken in their trades. Adherence to stop-losses can lead to the big market reactions.
Take this chart of the Chicago Board Options Exchange Volatility Index for example.
After a period of low rates and stable economic growth in the US the economy we had the sub-prime crisis and the GFC which saw an acute spike in market volatility as stocks crashed and forex and commodity markets were roiled.
Since then we have had three more periods of stability that then transitioned into volatility spikes. That latest episode has been in the past quarter as concerns over China, global growth and the Federal Reserve’s tightening cycle saw traders start to get skittish.
Put simply volatility increases because traders, used to to certain level of uncertainty, become uncomfortable with new information which either takes, or threatens to take, uncertainty above a level they are comfortable with. This cause positions to be cut, feeding the market tension and leading to more uncertainty.
It’s a negative feedback loop that tends to make volatility cluster – as Mandelbrot, and the chart of the CBOE VIX above, have shown.
But, traders have to cut their risks according to their risk management protocols. Because without these they are no longer trading – they are punting. And that is a recipe for a falling balance in a trading account.
The best traders scale their position sizes down to take account of the increased volatility which is seen in wider market ranges, bigger daily falls or rallies, and in doing so keep their market risk (how much they can lose on any given trade) constant through the cycle from low to high vol.
For example if a market with an average daily range of 75 suddenly spikes to 150, sophisticated traders will usually halve their positions to keep the amount of their trading account at risk on each trade constant.
That way they can continue to trade their system through the increased volatility until the market stabilises again. When that happens they can go back to their usual trade size.
That’s important because it’s about the trader’s individual risk preferences and style of trading, and how that fits market price action. Even traders who love volatility will use position scaling to manage their risk.
Other traders may exit positions, uncomfortable with the increased volatility and in the knowledge that there will always be another trade.
That’s entirely appropriate as well, and is something many professional traders, and their banks’ risk managers, will often do when volatility rises.
Of course the middle ground between continuing to trade with reduced positions and not trading is hedging your position by taking an opposing position in the market to cover some or all of you position.
For example a trader long a portfolio of stocks on the ASX may wish to hedge their position by taking an opposite index position. That reduces risk back to an acceptable level and can be achieved via futures, options or CFDs. Similar strategies can be used in currencies, commodities and other traded instruments.
While that may reduce the volatility in your portfolio by reducing your market risk, hedging in this manner comes with the added complication of knowing when to lift your hedge. You’ve reduced volatility, but not uncertainty.
But that’s trading.
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