If there is one characteristic that distinguishes long-term from short-term speculators, passive investors from active traders, it’s their response to market volatility.
Volatility is a statistical measure used to assess the dispersion and variance of returns for a given asset over a period of time.
Assets on the low end of the volatility scale tend to move in a steady, smooth, and seemingly gradual or incremental manner. Assets on the high end of the volatility scale tend to exhibit movements that are more jagged, faster or variable in speed (sometimes suddenly fast or slow), and unpredictable. The higher the volatility, the riskier the asset.
The important point here is that volatility can mean different things to different market participants: to long-term or passive investors, volatility may be seen as a negative, often referring to a decline in asset prices, or an uncertainty in the rate of an asset’s positive returns; whereas to short-term or active traders, volatility may be a welcome factor, as it provides short-term trading opportunities to go either “long” or “short” a given market.
For traders, there are many ways to take advantage of volatility. Here is a simple introduction to 4 general approaches to trading volatile markets. These descriptions are not meant to be comprehensive. To learn more about these strategies–namely, how to use them–you will need to do further research.
Approach 1 : Non-Directional Trading with Options
What if you want to go “long volatility” no matter what direction–up or down–the market goes? Two ways to do this would be to buy an options straddle or strangle.
Straddle: To build an options straddle position, you would need to buy both a call and a put at the same strike price.
Strangle: To put on a strangle position, you would need to buy a call above the current strike price and a put below the current strike price.
Both positions can be expensive to put on, as you would need to purchase the “premiums” of both contracts to construct the position. However, your risk is also limited to the price of the contract you had purchased plus commissions, fees, and other transaction costs.
Profit can be generated if the underlying price of the asset moves significantly up or down from the current market price. Hence, these strategies are literally “long volatility.” Without volatility, if the underlying price remains within a relatively close range from where it was when you purchased the calls and the puts, you will lose the amount of premium you paid due to price decay. You will need to do further research to learn more about how to forecast breakeven, profit, or loss levels.
Approach 2 : Non-Directional Trading with Futures
There are many forms of spread trading. The strategy we’re about to discuss here concerns two indices that are highly correlated, meaning that they tend to move in the same direction. A strong example of correlated indices are the S&P 500 index (ES) and the Dow Jones Industrial Index (YM).
Typically, when the one index moves up or down, the other is not too far behind. But what if one index gets too far ahead or behind? This is where you would need to know how to measure the spread between the two instruments, determining a “mean” above or below which you might assess that a spread has widened too far apart. If a spread trader identifies a spread that s/he considers too wide, s/he may choose to go short the index that has risen the most and go long the index that is lagging behind. The spread trader hopes that spread will narrow, and that either one leg or both legs of the spread may yield a profit.
In this scenario, you are not concerned with whether the US indices are moving up or down, rather you are trading the movement between the two indices. Hence, your basis for placing trades is “non-directional” with regard to the broader equities market. Spread trading is a relatively complicated and risky strategy, so you should plan to do extensive research before attempting this approach.
Approach 3 : Directional Trading with Futures
A more direct way to trade volatility is to trade in the direction of an asset’s momentum. This approach is also typically what short-term speculators attempt to accomplish. It’s important to note that within a long-term trend, say, in the case of a bull or bear market, there may be plenty of smaller trends or fluctuations that present traders with both long and short trading opportunities.
One of the more common approaches to trading short-term momentum is to respectively buy or sell (short) breakouts from technical resistance or support levels. As simple as this may sound, it’s actually much trickier than most traders think. And if you are going to attempt such a trade, it might help to have predetermined profit and stop-loss targets. Not only will these targets help you determine where to exit a trade, they may also help you determine your risk-to-return ratio, allowing you to evaluate whether a trade presents more risk than potential payoff.
Approach 4 : Counter-Directional Trading with Futures
Volatility can sometimes be characterized by sharp movements that progressively swing toward one direction and then to another. Each swing has a relative degree of momentum, and the momentum driving a given swing invariably has a limit (nothing moves straight up or down indefinitely).
When might a swing reach its limit before potentially reversing? One way to help measure such a limit would be to establish a mean or an average price and then a standard deviation above or below that price. This is where Bollinger Bands may come in handy. Bollinger Bands’ default setting consists of an exponential moving average plus two outer bands that representing the 2nd standard deviation above and below the average.
In volatile markets, the bands expand and act as potential resistance (upper bands) and support (lower bands). When markets are volatile, you might use the outer bands to determine when they might reverse–a potential “fading” or counter-directional trading opportunity. Like all of the other strategies mentioned above, this one can be very delicate as it may involve going against a trend. If you want to learn one way of fading the market using Bollinger Bands, check out our article: https://www.gffbrokers.com/using-pin-bars-bollinger-bands/.
For the active trader, volatility signal the presence of trading opportunities. And it goes without saying that with opportunity comes risk. How you take advantage of volatility, and how you exercise risk and money management can mark the difference between a calculated risk versus a reckless wager.
Although there are plenty of strategies that you can use to trade a volatile market, the four approaches mentioned above can at least serve as a basic introduction to different ways of building your trading strategy when the markets appear volatile.
Please be aware that the content of this blog is based upon the opinions and research of GFF Brokers and its staff and should not be treated as trade recommendations. Be advised that there are instances in which stop losses may not trigger. In cases where the market is illiquid–either no buyers or no sellers–or in cases of electronic disruptions, stop losses can fail. And although stop losses can be considered a risk management (loss management) strategy, their function can never be completely guaranteed. There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.