What traders should know about volatility
Winds of change
Changes in the price of financial instruments define our trading decisions and without those price changes, life in the markets would be very boring rather than the dynamic place we have come to know. However markets can be quite picky about the price changes, they want to see.
Markets dislike uncertainty in all forms and uncertainty about price changes is no exception.
Markets are most comfortable when prices move in a regular pattern or trend either up or down because these trends provide a sense of predictability or order.
An obvious example was the decade-long rally in US equities as seen in the chart below.
On a long-term chart, such as this monthly plot, the rise of the S&P500 index over the last decade looks like a largely uninterrupted move from the bottom left to the top right-hand side of the page, a textbook uptrend.
However, if we drilled down into the data, we would find that move higher was punctuated by sharp corrections or reversals, and those countertrend moves are exactly the kind of thing we have in mind when we talk about volatility.
What is volatility?
In the markets, volatility is a measure of the likelihood of a rapid change in the price of a financial instrument. Volatility is expressed as a percentage between 0 and 100 and that figure expresses the probability of a rapid price change in a given instrument or market.
Volatility is derived by looking at several factors including the history of price change in an instrument and current interest rates or rates of risk-free returns (we won’t concern ourselves with the math’s here but suffice to say that Nobel prizes were given out for the development of the equations that allow us to calculate volatility).
What we can say is that the more stable an instrument’s history of price change has been then the lower its volatility is likely to be and vice versa.
Volatility does not concern itself with individual price changes in an instrument, but rather the speed at which prices change, or vary over time in an instrument, such as the S&P 500 index.
Measures of Volatility
Work by Robert Merton, Myron Scholes and Fischer Black in the 1970s created the equations that allowed analysts to model and value the markets with a greater degree of accuracy.
Part of this modelling was the ability to calculate volatility, and to do so in two forms:
The Historical Volatility of an instrument, its track record of sharp price changes if you like.
The Implied Volatility of an instrument, is a prediction about the likelihood of sharp price changes in the instrument, in future.
The ability to make this calculation would put volatility centre stage and it paved the way for the creation of specific volatility indices. The most well-known of which is the VIX index which tracks the changes in the implied volatility (or probability of future sharp price changes) in the top 500 US equities.
Greed and Fear
The VIX has become known as the “greed and fear index” on the basis that when markets are “greedy” prices tend to move in the same direction at the same time. Traders and investors are bullish and are buying or going long the markets.
However, when markets are “fearful” traders are more concerned about losing money rather than making it and they are likely to sell assets to bank profits or to avoid potentially larger losses in future.
In the three-year chart of the VIX index below we can see the index is prone to its own sharp upward moves. Those moves higher are what are known as spikes, these are the points at which trader’s emotions switch position, that is when fear outweighs greed.
Or to put it another way when volatility spikes higher traders move to a risk-off stance and when volatility subsides once more, then markets and traders within them move back to being in a risk-on mood.
Traders should have a healthy respect for sharp changes in volatility because they can come out of the blue, and in the worst cases, they can be unknown unknowns, Black Swan events that arrive unseen disrupt everything that has gone before. Such events are relatively infrequent but they can and do occur.
For example the Yen flash crash in January 2019, the removal of the Swiss National Bank’s peg between the Swiss franc and Euro in January 2015, and of course the emergence of the Covid-19 virus early in 2020.
Traders can try to use volatility to their advantage for example after a period of heightened volatility markets often tend to calm down once more. We can see that behaviour in the chart above where we see volatility spikes and risk-off behaviour followed by a correction and a return to lower levels of volatility and resumption of risk-on behaviour.
When traders talk about buying the dip it’s this kind of price action they have in mind. However, it’s dangerous business to try to pick tops and bottoms. it’s generally considered a better idea to let the market tell you when it’s found a floor or reached a peak
Another way that traders can use volatility is when they are trying to decide what instruments to trade. Many of us stick to a shortlist of favoured instruments we regularly trade. However, others are more adventurous and they start each day with a “blank piece of paper” and look for opportunities.
Instruments that are experiencing higher levels of volatility are likely to experience larger price moves more than their low volatility counterparts, larger price moves create the chance for a trader to capture a bigger profit on a trade. Of course, there is also a risk of a larger loss in trading a more volatile instrument.
Traders need to be aware of volatility and the changes within it, they should be cautious when volatility spikes higher, as it indicates uncertainty and unease in the markets, a change from previous price action or regimes.
Spikes in volatility can be caused by rapid price changes in either direction, but they are mostly linked to large downside moves when market sentiment becomes risk-off
Traders should take less risk in periods of high volatility. That said the periods after a downside correction can offer trading opportunities, once the markets settle down once again. However traders should not attempt to pick these points for themselves, rather they should let the markets tell them they have found a bottom.