How to Deal With Market Volatility in Your Favor
No matter what market you want to invest in, you will definitely meet with volatility. Volatility is an essential part of financial markets. The most common mistake of newbie investors is that they believe that volatility can appear and disappear.
The volatility always exists. The only difference that determines the success of your investment is the strength of volatility. Let’s clarify how to use the power of price volatility in your favor.
What Is Volatility?
In common words, volatility is a measure that determines the rate at which the price of the security changes for the set of returns. Volatility is used to determine the market fluctuation and understand whether the asset is risky or not. It is calculated by a standard deviation.
As we said above, volatility has different grades. It can be high, medium, and low. The higher the volatility is, the riskier the security is.
Volatility is used to determine the market fluctuation and understand whether the asset is risky or not.
There are well-known examples of markets and securities that relate to a specific volatility grade. For instance, the oil market is considered as a highly volatile one. The silver market is known as having low volatility. If we are talking about Forex, the Australian dollar and New Zealand dollar are generally known as highly volatile. However, the grade of volatility will also depend on the period you consider.
The stock market, in general, is a subject of high fluctuations. At the same time, the volatility grade may differ regarding the stock you trade. For example, Microsoft stocks have a medium rate of volatility as Microsoft is a blue-chip company. While shares of a new company that is barely known in the market will be highly volatile.
It’s crucial to understand that the same asset can be commonly considered as risky (being subject to high volatility). Still, its volatility will depend on the period you consider.
Types of Volatility
Although there is a general term for volatility, it’s essential to understand the difference in its types.
This type is also known as backward-looking. To calculate the historical volatility, you need to determine the asset's standard deviation from its average price for a particular period. You can use both intraday prices and close prices. The average period of intraday calculation varies from 10 to 180 days.
Historical volatility is backward-looking.
For example, if the price of a stock has an average volatility of 20% within the past period of 100 days and 30% within the last ten days, it means the volatility has increased.
When historical volatility rises, it’s more likely that the asset's volatility will deviate from the standard. Thus, it’s either something that will affect the market that has happened or will happen soon. At the same time, if the historical volatility declines, the market will return to the usual conditions.
Unlike historical volatility, implied volatility is forward-looking. The type is mostly used for options trading. To calculate the implied volatility, it’s not possible to take historical data. It’s essential to evaluate the potential of the option in the market.
To do that, traders gauge supply and demand. Seeing a significant deviation in them, the trader can expect changes in the price of the asset (mostly stocks) they plan to consider. Options premium serves as a barometer. It rises in price when there is a sharp deviation in either supply or demand, and falls when the value is near equilibrium.
Implied volatility can’t predict the direction of the security’s price but can predict where the volatility will be in the future.
Traders can combine historical and implied types to determine whether the security is overvalued or undervalued. If both types show the same values, then the security is supposed to be reasonably priced. After that, traders consider deviation from the equilibrium to define whether the security is undervalued or overvalued.
Besides two major volatility types, there is another one. It’s intraday volatility. The name clearly shows the core of this type.
Intraday volatility depicts asset fluctuations between open and close prices within one day.
To calculate volatility, you need to measure the range of the previous trading day. The range is measured by the difference between the highest and lowest prices. Afterward, traders decide what percentage will be comfortable for them to enter the trade. Mostly, they use 70%. A higher percentage is considered less risky to enter the market.
To make it easier, let’s look at an example. Let’s assume a day before an asset traded in the range of $6.5-$7.50. So, the range is $1, or 100 cents. If you want to enter the trade at 70%, wait until the price is 70 cents above the open price (buy position) or 70 cents below the price (sell position).
How to Calculate Volatility
There are two main methods to calculate the volatility. They are variance and standard deviation. However, they are interconnected. The standard deviation is measured as the square root of the variance. Look at the steps below:
- Let’s imagine you count volatility for the last 10 days. For that, you need to take close prices for those days. To make your calculation easier, it’s better to use Excel.
- The second step is to count the mean of these figures. You should add each figure, then divide the sum by the number of values.
- Let’s imagine; the close prices went from $10 to $100. So, on the first day, we had $10, on the second $20, etc. As a result, we have $550. After, we divide 550 by 10 you get $55.
- The third step is to find the deviation. All you need to do is to take each figure and subtract the mean from it. For example, $100-$55=$45, $90-$55=$35, etc. It’s more likely you will have negative means, which is acceptable.
- To remove the negative values, just square the deviations.
- Add squared deviations together. In our example, we have 825.
- The next step is to divide the previous sum by the number of figures (10). As a result, we have $82.5.
- And the final step to get the standard deviation is to calculate the square root from $82.5. As a result, our standard deviation is approximately $28.7. This number shows how far the price can deviate from the average mean.
What Can Affect Volatility?
Volatility always exists in the market. However, it’s essential to know how to predict it. It’s much easier to forecast volatility than to calculate it. High volatility exists when the number of either bulls or bears enter the market. Why do they enter the market? Because an event will or has affected the asset.
If you have read something about financial markets, you know that factors, which have an impact on them, differ. Nevertheless, we can group them.
No matter what market you trade in, the news is a vital driver of any of them. News can be predictable and unpredictable. For example, when you know that there will be presidential elections in the country, you can expect that the domestic currency volatility will be far ahead, during, and after the results are published.
News can be predictable and unpredictable. Both types create high market fluctuations.
However, there is unpredictable news. For example, the oil prices suffered a collapse after Russia and Saudi Arabia couldn’t agree on oil output cuts. The oil-price war led to a plunge of WTI prices, which caused negative levels for the first time in history.
Macro- and microeconomic factors influence each financial market. Economic events are predictable. Thus, you can easily predict volatility strength. These events relate to economic data of a country, an industry, and a company (important for stock and bond markets) and show their economic health. The events are always mentioned in the economic calendar.
Economic events are predictable and listed in the economic calendar.
However, not all of the economic data mentioned in the calendar causes high volatility. Every calendar marks events as not important, important, and highly important. Those which are highly important are supposed to lead to big market fluctuations.
There are two main stages when high volatility can be found in the market. The first one is ahead of the release. Almost every economic event has a forecast made by analysts. Thus, if there is a large gap between the previous data and the estimations, the asset is supposed to experience huge fluctuation several hours before the actual data is published.
The next stage is the time when the actual figures are published. If they have a vast difference with the forecasts, the volatility will increase even more. This event has the most significant effect on the market from 30 minutes to two hours after the actual data was published. Thus, traders should expect the volatility to decrease in a minimum of two hours after the data is published.
Lack of Interest
We mostly talked about wide market fluctuations. It’s also important to mention low volatility. Low volatility appears when traders or investors don’t want to put their money in the security. It can be due to the holidays, risk grade of the asset, or if the asset is not highly used.
Volatility: Pros and Cons
Although, it seems volatility may negatively affect the profitability of the trade, it also has benefits. Let’s look at them.
High volatility, high rewards. We always remind you of this rule: the higher the risk is, the bigger reward you get. High volatility causes substantial market moves.
High risks. High volatility causes risks of money loss as it’s almost impossible to predict how the market will behave. However, if you trade with a reliable broker, your losses will be limited.
Libertex uses a margin call that will warn you when your budget comes closer to a limit you can’t exceed to keep your funds. Also, the broker can close your position to prevent you from entering a negative budget.
Exciting market. Did you come to the market to sit and wait until the price moves at least a bit? We are sure that goal aim is different.
Only significant market moves create a place for big rewards and breathtaking trades.
Low volatility, low rewards. As volatility can not only be high but low, it’s essential to understand that low volatility signals traders are not interested in the asset.
As a result, it is unlikely you will get a significant reward for your trading.
Difficult to predict. Although there are predictable factors that affect the grade of volatility in the market, it’s not that easy to forecast the strength of volatility.
Lack of ability to predict volatility creates challenges for investors.
Why Volatility Matters to Investors and Traders
The degree of volatility is crucial for traders and investors, as their profit depends on the ability to predict the market direction. High volatility makes market moves significant. Thus, it’s complicated to predict the direction of the price.
Volatility and liquidity are interconnected. Low liquidity increases the risk of high volatility.
Volatility also relates to liquidity. Every trader and investor knows that market liquidity weakens during the holidays and is always low in the exotic markets. Low liquidity causes high volatility, as there are not enough market players who can smooth out the market moves.
We talk a lot about volatility and its effect on markets but haven’t said anything about indicators that will help to determine its grade.
Bollinger Bands is a standard indicator implemented in most of the trading platforms, including MetaTrader. The indicator consists of three lines, where the middle one is a Simple Moving Average with a period of 20 and two outer lines representing the deviation from the middle one.
The standard setting is 20 for the middle line. However, you can change it regarding your trading strategy. It’s recommended to use a period from 13 to 24. At the same time, the deviations should be in the range of 2 to 5.
The indicator is used to define how significant the deviation from the average price is. The distance between the lines shows the strength of volatility. Thus, when they are close to each other, volatility is low. When they sharply diverge, the volatility increases. Look at the example.
Average True Range (ATR)
Unlike the Bollinger Bands indicator, ATR is placed in a window below the chart. The index shows a moving average of true ranges. True ranges are calculated as the absolute value of the current high subtract the previous close, or the absolute value of the current low subtract the previous close.
The indicator consists of one line. To determine whether the market is highly volatile, a middle line must be drawn. However, there is no central line for this indicator. You should draw it by eye or use the 100-period Moving Average and implement it on the index. Thus, if the indicator is above the middle line, the market is highly volatile. If it is below the line, the market has low volatility.
The ADX indicator is mostly used to determine the strength of the trend. When the indicator enters a zone below 25, it means there is no trend. Thus, the market consolidates. If it consolidates, it means the volatility is low.
Volatility in Different Markets
Although volatility is a commonly used term, it slightly differs regarding markets.
Stock Market Volatility
Whether you are a stock investor or a CFD trader, the market volatility will determine your strategy. As we said above, factors that determine volatility grade are almost the same for all markets. Trading stocks or investing in them, you should consider news and economic events that will either affect the company, or the industry, of the economy in general.
To evaluate market volatility, you can use the same indicators used for Forex. However, there is one specific one. It’s the CBOE Volatility Index (VIX). The Chicago Stock Exchange launched this index in 1993. It reflects market volatility based on the price that investors are ready to pay for the companies' stocks in the S&P 500 index.
At the beginning of the article, we talked about silver and oil markets. The oil market is known as one of the most volatile, while the silver market is a safe-haven market. As you will hardly find economic releases for commodity markets, except crude oil inventories data for oil, news and global market sentiment determine the market moves.
There are two types of traders: those who prefer to avoid volatility and those who take a chance to get fast results using the highly volatile market. High volatility is a result of news and economic events that attract either bulls or bears. Those traders who are eager to get fast results, trade on events, and try to predict the market direction.
High volatility appears when markets wait for economic or political events. For example, if you trade GDP growth data of Canada, it’s unlikely the actual data will significantly exceed the forecast. However, if you want to trade on OPEC negotiations regarding oil production, it’s doubtful you will be able to predict what parties will agree on.
As the outcome of many events is barely predictable, it’s crucial to choose only those events whose outcome you can forecast.
You can either enter the market ahead of the event based on the analysts’ predictions or trade on the increased volatility. However, you must close the trade when the release is out. Otherwise, you risk losing your money. If you want to trade as soon as the event is out, open a position within the first five to 10 minutes.
Those who are not fond of risk use markets with lower volatility. If we talk about Forex , such major currencies as the US dollar, Euro, Japanese Yen, and Swiss Franc experience lower volatility, as the market liquidity is really high.
At the same time, to lower the volatility grade is enough to check the news and economic calendar on a daily basis. As soon as you see, there will be an economic release, or a significant political or economic event, close open positions at least two hours before the release is out. You can re-open the trade, no earlier than two hours after the data or news are out.
Tips for Trading in Volatile Markets
If you want to trade carefully during volatile markets, here are some things to keep in mind:
- Choose what volatility suits your strategy. The first thing you need to consider is whether you want to risk and trade in times of high volatility, or if you would better to avoid it.
- Choose the indicator that matches your strategy. It’s essential to have assistants, such as indicators, that will help you determine the degree of volatility. We mentioned three of the most used indicators that will surely help you to gauge volatility.
- Build your own strategy. There is no perfect volatility strategy. If you want to trade on high volatility, check the economic calendar or news that will give you clues on the events that may make markets highly volatile. If you prefer avoiding market volatility, use indicators that will show you whether the market is highly volatile.
To conclude, volatility is an integral part of any market. To be successful in investing or trading, a person should know what factors affect the volatility grade. High volatility is not as bad as many might think, as it brings fast results. Moreover, if you trade with a reliable broker, you will avoid many obstacles. For example, Libertex uses a margin call to warn its clients if they touch the determined budget limit.
Also, low volatility is not always good as it may limit desirable results. To determine what volatility conditions suit you the most, Libertex offers a demo account that fully duplicates the real market.
Finally, let's answer essential questions on this topic.
What Does Volatility Mean?
Volatility is a measure that shows the rate at which the price of security changes for return. It gauges the strength of market.
Is High Volatility Good or Bad?
It depends on your trading strategy. In general, high volatility creates a risky situation with a lack of opportunity to predict market moves. At the same time, high volatility is an option to get a higher reward.
What Is Considered High Volatility?
High volatility is a market condition when the price rises or falls significantly within a short period of time. It’s easily seen on the chart as the price forms long candlesticks.
What Causes Volatility?
Volatility always exists. High volatility is influenced by market events such as news and economic releases. Anything that can lead to either inflow or outflow of funds in the market creates high volatility. Low volatility is based on the lack of investors’ willingness to invest in a security.
How Is Volatility Used in Trading?
To trade successfully, traders should be aware of the possible volatility grade. High volatility is considered as a risk factor, and lots of traders prefer avoiding it. Thus, they don’t trade on news or economic releases. Those who prefer to take a risk and get fast results use high volatility.
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