Volatility describes how quick and how much the price of a security or market index has changed. Volatility is linked to risk, as normally the more volatile an asset is, the riskier it is for a trader.
Volatility is arguably the most misunderstood concept in the investing community. While professional traders live on volatility, many beginners to the market don’t know what volatility is and how to trade on it. Without volatility, there would be no significant price movements in a short period of time, and traders would have a hard time to catch profitable trades or to make profits at all.
That’s why we’ll cover the importance of volatility in the following lines, show what it is, how to calculate volatility and how to take full advantage out of it.
What is Volatility?
Volatility is a statistical measure of the deviation of returns for an investment or financial instrument. Simply put, volatility refers to the amount of price change over a given period of time. The more the price tends to change over a given time span, the higher the volatility of the financial instrument. A highly volatile asset would move erratically and experience impressive increases and dramatic falls in price.
A less volatile asset, on the other hand, would hardly move at all. Combining financial instruments with different volatilities can also be used to diversify the investment risk in a portfolio.
What is Implied Volatility?
The term implied volatility refers to the estimated volatility of a financial instrument’s price in the future. Implied volatility is commonly used in options pricing and increases during downtrends and decreases during uptrends, because market participants usually consider bearish markets as riskier than bullish ones.
While volatility is usually measured by the variance or standard deviation in statistics, we’ll describe a more practical approach for traders. In the Forex market, traders can measure volatility by using volatility indicators such as Bollinger Bands or the Average True Range.
The former indicator plots two bands – one upper and one lower band – at a distance of two standard deviations from a centrally-located moving average. In general, the more the bands widen, the higher the volatility of the underlying instrument. The following chart shows period of low and high volatility, identified by using Bollinger Bands.
The Average True Range, developed by Welles Wilder, is also a volatility indicator which uses a smoothed moving average of historical true range values. The true range is calculated as the largest of the: previous period’s high minus previous period’s low, absolute value of the recent period’s high minus the previous close, or absolute value of the recent period’s low minus the previous close. Don’t worry, your trading platform will calculate this automatically for you.
Simply put, a higher ATR reading implies higher volatility in the market, as shown on the following chart.
Alternatively, traders can use a volatility index to track the current market volatility, such as the VIX or CBOE volatility index.
How are Volatility and Risk Related in an Investment?
High volatility is usually associated with riskier investments. Since volatility can work both for and against a trader, trading very volatile financial instruments should be taken with caution. In the Forex market, major pairs which include the US dollar as either the base or counter currency usually fluctuate to a smaller extent and are significantly less volatile than pairs that include exotic currencies, such as the Turkish lira or Mexican peso. This means that major pairs carry less risk for traders, but also dampen the profit opportunity.
How to Trade Volatility?
While trading highly volatile financial instruments can be very lucrative, traders need to pay attention to proper risk management when doing so. Using stop-losses is mandatory when trading on high volatility in order to have potential losses under control and avoid a margin call.
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A popular trading strategy to trade on volatility is called the Bollinger Band Squeeze. When Bollinger Bands tighten in times of low volatility, this is usually a sign of upcoming volatility which can be successfully traded with the BB Squeeze.
Simply identify a squeeze in BB bands and wait for the price to close outside the Bands in either direction. An outside close triggers a trade in the direction of the price momentum. In the example above, a short position would be executed after the bearish candle closed below the Bollinger Bands, with a stop-loss placed above the recent swing high.