Embracing Volatility for Trading Confidence

Embracing Volatility for Trading Confidence

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  • It’s no secret that market volatility has been elevated in 2020, but for those waiting for the dust to settle you may be waiting a while - the reality is the levels of volatility we’ve seen looks set to continue well into 2021.
  • Volatility itself, however, should not be feared; instead it can be harnessed as part of a successful trading and risk management strategy.
  • Harnessing volatility requires investors to estimate it accurately, and in order to gain an edge, traders must equip themselves with the right tools to measure and manage this.
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The storm clouds of volatility have been roiling all year, and don’t appear to be abating anytime soon. Since February 2020, when the world woke up to the full effects of the pandemic, the CBOE’s Volatility Index (VIX) has surged to levels unseen since the Global Financial Crisis. And it's still up there. In fact, its lowest level thus far in 2020 still exceeded its highest point in 2019.

The effect of volatility has also been felt in the currency markets. Deutsche Bank’s Currency Volatility Index, for instance, has spiked sharply twice this year – once at the onset of the pandemic, and another in July when evidence of a second wave emerged.

Then there are the other volatility catalysts – global unemployment, political tensions, and uncertainties surrounding a global vaccine and government stimulus, not forgetting the impact of the recent US presidential election, all of which will persist well into 2021.

But is this seemingly never-ending volatility something traders and investors should fear during their quests for market opportunities?

Discard fear. Embrace volatility.

For those of us in the active markets, volatility can be a scary word, carrying connotations of risk and loss. But viewing volatility through that lens does not make a trader successful. Volatility, like all risk factors, needs to be considered pragmatically and strategically as part of an informed trading approach. Volatility could be thought of as fire: dangerous when used recklessly, but a powerful tool when harnessed correctly.

Chris Weston, Global Head of Research at Pepperstone says, “Volatility is at the epicentre of markets. Whether we’re looking at past movement or implied it defines our strategy and time in the market (in front of our screens) and is an essential consideration for efficient risk management and guiding to correct position sizing.

The explosion in both volatility products and the use of volatility strategies within the institutional world is testament to that, but it should be a consideration for all retail traders too.”

This flow of dollars points to an indisputable conclusion – volatility matters (a lot).

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In volatility we trust

Both traders and investors alike benefit from volatility and that’s because volatility generates potential returns. The rule of the markets holds that taking on additional risk and volatility must be compensated for.

"In the absence of volatility, assets would struggle to generate a return, with investors searching for whatever yield they can find across asset class. With interest rates at the zero lower bounds, and when adjusted for inflation, finding a real return just means taking on ever higher degrees of risk."
Chris Weston
Global Head of Research, Pepperstone

High risk, high growth

In fact, for traders who have shorter time horizons, volatility matters even more. Higher volatility equals greater price fluctuations (from a mean of a defined period) which creates more profit opportunities.

Trading strategies

There are also specific trading strategies based on volatility, particularly when using instruments such as options. For example, a long straddle would benefit from increasing volatility, while a short straddle can be used to profit from falling volatility.

Risk-off alternatives

However, not all traders may wish to wade into volatility’s choppy waters. For those traders, there are various safe haven assets where they can find refuge. Gold is a common example in the commodities space. Looking at currencies, currency pairs such as the dollar-yen are popular risk hedging vehicles.

Your exclusive guide to volatility

Check out Pepperstone’s proprietary weekly Volatility Matrix, providing traders an overview of the implied volatility for 11 common currency pairs.

Much more than just a trading strategy

Beyond volatility’s importance as a source of potential returns, it is also an essential component of risk management. This is largely because volatility measures movement and quantifies what's expected - which can be very powerful, not just for position sizing, but whether the market views a specific event risk as a market mover or not.

A commonly held misconception is that volatility equals risk.

This is a common misconception that arises because volatility can be precisely measured, while the full dimensions of risk include aspects that are not as easy to quantify.

This quantifiability of volatility can be very powerful, not just for position sizing, but whether the market views a specific event risk as a market mover or not.

Still, while volatility doesn’t necessarily equal risk, it’s a major contributor to risk. So understanding volatility and how to harness it in your trading approach makes it a vital part of any risk management strategy. One example of this in practice is volatility targeting, whereby portfolio allocations are dynamically adjusted based on specific volatility thresholds.

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How to identify volatility

Like any asset class, volatility displays its own inherent characteristics. The two main ones being mean reversion and clustering. Over the long term, volatility tends to fall back to its long-term average, while in the short term, high volatility periods are usually followed by periods of also-high volatility (and vice versa). Volatility also displays low correlation to other asset classes, meaning it can be used to enhance portfolio diversification and improve risk-return profiles.

Volatility is predictive.

Empirical research supports this showing that implied volatility (the forecasted volatility) can produce robust market timing signals thereby giving traders an undeniable edge.

Looking at it this way, volatility could arguably be classified as an asset class in and of itself. The advent of the VIX – and the various funds and instruments linked to it – give multiple options for investing and trading in this asset class. While most traders welcome higher volatility regimes, more risk adverse risk adverse traders seeking to overcome a potential fear of volatility can also take advantage of Pepperstone's analytical trading tools such as AutoChartist and Smart Trader Tools, a set of expert advisors, tools and indicators designed to help clients identify changes in sentiment and price movement, manage risk, test strategies and more.

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To harness fire, we need the right tools

Volatility is powerful – both as a trading strategy and as a part of overall risk management. But harnessing its power requires effective analytical tools for measuring it as well as efficient platforms that enable traders to seize opportunities that may only exist for an instant.

With its support for the MT4, MT5, and cTrader platforms – plus precise analytical tools – Pepperstone has equipped its 89,000+ traders with the edge they need to confidently navigate even the most volatile markets. As Chris Weston, Global Head of Research at Pepperstone says, “Volatility undoubtedly creates opportunity, but it can also be a helpful guide to stay out of the market. If utilised correctly within a process, volatility can genuinely help cultivate your edge as a trader, helping you protect and grow your capital.”

This page was paid for by Pepperstone. The editorial staff of CNBC had no role in the creation of this page.