The return of volatility

The summer saw markets enter a quiet period, with this coming to an abrupt end in September. But when people talk about volatility, what do they mean, and how can traders deal with it?

In my experience, when investors, traders and financial news channels talk about ‘volatility’, they tend to actually be talking about markets that are going down. Nobody complains about volatility when markets grind steadily higher day after day, or when a sudden charge higher by an equity index is followed by further gains. Instead, volatility is a shorthand for rapid falls in markets, such as those seen in the wake of the Brexit vote in June.

In actual fact, volatility is merely a statistical measure of the returns for a given security. The higher the volatility, the riskier the security, ie its price can change dramatically over a short period of time (both up and down). One way of measuring the volatility of an asset is to look at its beta. Beta seeks to approximate the volatility of a security’s returns against a benchmark. A stock with a beta of 1.2 has, in the past, moved 120% for every 100% move in its benchmark.

For indices, and in particular the S&P 500, investors often look at the Volatility Index, or the VIX. The index measures the market’s expectation of volatility over the next 30 days, using the implied volatility of a range of S&P 500 options. Generally, when the VIX goes above 30, it indicates a large amount of volatility due to investor uncertainty, and when it falls to 20 or below investors are assumed to be complacent. August 2016 saw some of the lowest volatility readings in many years, which led some to warn that a period of higher volatility was approaching.

However, the VIX itself is not a predictive tool. A low VIX does not imply that markets are about to spring to life. It is a derivative of price, and as such cannot predict what the price will do. Instead, the VIX more closely approximates to the inverse price of a security, in this case the S&P 500. It is important to remember that a rising VIX does not always mean that prices will go down. Between 1995 and 1997, the VIX tripled, but the S&P 500 gained 47%, in one of the most sustained rallies in recent history.

All markets go through periods of quiet and then excitement. Traders need to learn how to deal with this, as getting caught out can lead to good trades being stopped out. If markets have become volatile (eg they are seeing wide daily ranges), then it is a signal to traders to do two things – reduce their position sizes and widen out their stops.

The first means you will experience smaller swings in your profit and loss, and thus will likely remain calmer about your trades, and crucially, will be less tempted to close out a trade before it has time to turn profitable.

The second rule allows positions to last longer, riding out the movements and avoid getting caught in a sudden spike or drop. Traders should always be prepared for volatility, but especially during quiet periods, when smaller daily ranges may encourage them to increase their position sizes. It is best to assume that volatility will return at any point, and avoid the temptation to overleverage on any trade.

Markets have now come back from their summer break, and we have already seen days of swift losses, followed by days of equally dramatic rallies. These can bring interesting opportunities, but should be handled carefully. Knowing how to cope with volatility is yet another lesson that traders need to learn.

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