How to measure and trade coronavirus volatility
Market volatility has moved to levels not seen in decades amidst the ‘Black Swan’ event that is the current coronavirus pandemic.
With massive disruption and in volatility bought to the market place by the coronavirus pandemic, traders will do well to pay extra attention to managing risk through the sizes of their respective positions in the market.
What is volatility?
In the simplest of terms, volatility is a measure of price fluctuations over time. This could relate to share, commodity, index and forex prices.
Low volatility would highlight a narrow range of price activity, while high volatility would highlight a wide range in price fluctuations.
Which indicators can help me assess market volatility?
The two most popular indicators used in technical analysis to highlight market volatility are Bollinger Bands (and their indicator derivatives) and Average True Range (ATR).
Bollinger Bands are covered extensively on the ig.com website and detailed information on the indicators, written by Mr John Bollinger himself, can be located here.
For the sake of understanding market price volatility and using it to build a position sizing model we will focus on the ATR indicator.
Average True Range (ATR)
Average True Range (ATR) is a technical indicator which averages out a market’s price range over time. The indicator can be added to any market over any time frame to help traders identify the historical price volatility / range over a period.
For example, the ATR added to a daily timeframe of an index would identify how many points the index is seen moving (on average) over the course of a day. The ATR indicator added to a forex pair on an hourly time frame would identify on a how many points/pips (on average) the forex pair is moving in a day.
Read more detailed information on how the Average True Range Indicator is calculated and some further uses thereof.
Volatility stop loss
The ATR gives us an expectation of how many points/ pips / cents a market might move over a period. By knowing how much a security might move over a period we are given an understanding of the possible risk in the market over that period.
One suggested use for the ATR is using the value (or a multiple thereof) as a stop loss distance from a trade entry point.
For example, if the ATR value is 100 points, we could consider a stop loss distance 100 points away from our entry price. By using the ATR as a stop loss distance from our entry point, we are trying to give a trade enough breathing room by considering the inherent price volatility in the calculation.
In theory we would have to time our market entry as poorly as possible to be stopped out of the trade on a normal day if the 100 point stop loss applied to a daily time frame. This could still happen but should happen relatively infrequently.
Some traders looking for a wider stop loss and more breathing room in a trade, whilst still accounting for volatility, might consider using a multiple of the ATR value as a stop loss distance.
For example, if the ATR value is 100 points/pips, then we could use 2 x the ATR value as a stop loss distance i.e. 100 x 2 = 200 points stop loss distance.
Position sizing (how many contracts do I trade?)
The distance from our trade entry point to our protective stop level shows us how many points or pips we are risking in any one trade. We need to convert this into a currency value.
The below uses a currency pair example for the position sizing model, but the Index or commodities position sizing can be calculated in the same way, all you will need is the contract details (available on the deal ticket or website) and the monetary value of your preferred risk threshold.
Let us use the EUR/USD pair as an example.
A standard contract with IG Bank on the EUR/USD would mean that one pip = $10, while a mini contract with IG Bank on EUR/USD would mean that one pip = $1. For the sake of easy mathematics, we will use a mini contract for the following exercise.
So if our stop distance (using 2 x ATR as above) is 58 pips (29 x 2) and we are trading in mini contract lot sizes then:
58 pips x $1 pip = $58
So for every $1 mini EUR/USD contract we take, we would be risking $58 on this trade.
How many contracts a trader might consider trading can be referred to as our position size. A simple formula for this is as follows:
Position Size = Total Risk / Risk per contract (dollar terms)
We have defined the 'Risk per contract' in the previous section (Stop loss distance x value per contract/pip).
The 'Total Risk' refers to how much of your trading account you are prepared to risk in any one trade. Recommended guidelines would suggest not risking more than 2% to 5% of your trading capital, but this is personal to each trader. We recommend putting this Total Risk value into a currency amount. For example:
If Total Risk = 2% of account and account value is worth $10,000
Then Total Risk = $200
With this in mind, we can now calculate how many contracts to trade:
Position size = Total Risk / Risk Per Contract (dollar terms)
= $200 / $58
= 3 (rounded off)
So, to summarize as per the formula above, if we were to trade 3.44 mini EUR/USD contracts, with a stop distance of 58 pips, we would be risking $200 on our actual trade.
We did however round down our contract size to three, which would mean we would be risking slightly less in our trade ($58 x 3 = $174).
The ATR indicator helps us understand price volatility in whichever market we are trading. This volatility measure or a multiple thereof can be used by traders as a stop loss distance. This type of stop loss is referred to as a volatility stop.
The volatility stop can also be considered as the risk per contract traded. By using the formula ‘Position size = Total risk / Risk per contract’, we can position size in accordance with the risk we are prepared to take in the trade, accounting for the inherent market volatility currently present.
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