Normally, traders position themselves in the market with a view on direction. They believe it will go up or down and place trades accordingly. This article explains why it’s also important to consider volatility as part of your trading portfolio.
When trading a certain asset, buying it means you believe it will trade higher and selling means you believe it will trade lower. By placing a position, you are exposing yourself to unexpected losses in case the market trades in the opposite direction and is volatile. When placing a trade, you are required to put up margin which guarantees a limited amount of funds at risk in case the market moves against you. You can also put a stop-loss order where you decide the amount of funds you are willing to risk.These are part of your risk management variables. To assess the probability and magnitude of a possible move against you and avoid waking up to a much greater loss than you were willing to take or a position you no longer hold because you were stopped out, you need to understand the asset’s (such as currency pair or commodity) volatility.By considering volatility you have a better chance of avoiding anunwanted surprise.
An asset’s volatility measures its price fluctuation over a certain period of time. It is not an indication of market direction. When market volatility is high it means that the asset’s price fluctuates dramatically and the vice-versa is true when volatility is low, the price stabilizes. For example, in the gold market there is a clear difference between a 1% daily range and a 5% range. If the market is at $1500, a 1% daily range means that it can go up or down by $15 and 5% means it could go up or down by $75. With a given amount in your trading portfolio and volatility indicating a 1% daily range, you will take into account, as part of your risk calculation,the worst case scenario of a $15 move against you. If the market indicates 5% volatility you will need toreadjust yourstop-loss order to be able to afford a greater move against you.Youmay have a correct view on the market’s direction in the long term but if the move in your direction is volatile, you might be stopped-out before your price target is reached.
So how can you assess market volatility and use it to your benefit when trading?You can do so usinga financial instrument called Options.
When buying options you are trading a time limited, high leveraged product where your risk is limited to the price paid for the option and a crucial part of the option’s price is based on expected market volatility. This fact opens up a world of volatility trading, educated market speculation and hedging alternatives.
When I come across new traders they always mention getting stopped out of a trade and then then it moves in the direction they thought it would in the first place. Trading Options takes away this problem. Plus, when the volatility increases inexperienced traders get caught out because they keep the same stop distance. For example, if we see the average true range in the EURJPY go from an average of 130 pips per day to 160 pips per day, when know volatility has picked up so we may need to widen our stop loss order. We don’t have that problem in options but it’s so important to understand the basics of how volatility effects option pricing.