Volatility is alive and well, use it to your advantage

Three key variables traders may need to watch throughout october have to be sentiment towards China, US and Chinese financial conditions, and ultimately the implied probability of a hike in the Fed funds rate for the December and January Federal Open Market Committee (FOMC) meetings

US Reserve Bank
Source: Bloomberg

Sentiment towards China can be best viewed by China’s equity markets and the high-grade copper price, which will no doubt find buyers should Chinese data improve through October. Financial conditions are factors like credit spreads, money market rates, US treasury pricing, implied volatility, the S&P 500 and the rate of change in the USD.

It has become perfectly clear that the world’s most influential central banks have taken a dovish turn, with China at the heart of the concern. As of late September, we have already seen ten weeks of outflows from emerging market (EM) funds, equating to around $60 billion. As long as liquidity is moving out of these markets and EM central banks are drawing down their FX reserves to stabilise their exchange rates, then this will offset the liquidity being generated by the likes of the European Central Bank (ECB) and Bank of Japan. This is a major source of the volatility in asset markets.

Some will also put the volatility down to a credibility issue around the Federal Reserve (Fed) given its failure to act at the September meeting. Is US monetary policy ultimately driven by financial markets? Potentially, and it’s for this reason that the Fed would ideally want to hike rates in December if global financial conditions improve and interest rate markets are pricing in a higher probability of a hike. However, when it comes to credibility, perhaps this biggest issue is that the Fed will not achieve its 2% inflation target (looking at core PCE) on its current economic projections until 2018 and therefore, with the exception of a four-month period in 2012, would have missed the inflation part of its mandate for a whole decade! This is making traders and investors very nervous.

Markets are clearly searching for answers and price action reflects a strong divergence in opinions from all sorts of market participants. Though, if we take a step back and look at the weekly chart of the S&P 500, sentiment has clearly taken a turn for the worse and multi-year trend breaks have been seen. However, the biggest issue for traders is the sustained increase in volatility. Understanding volatility is an absolute must if you are to survive and thrive in current market conditions.

Volatility leads to traders acting irrationally, it leads to increased correlations in asset classes, and importantly it leads to ill-discipline. Trading plans and strategies often get forgotten, even though this is exactly the time when one is required. Understanding and reading volatility is therefore vital, as along with sentiment and positioning, volatility (or implied volatility) are the three most important variables to focus on when short-term trading. Technical and price action behavioural analysis are even potentially more important, but ultimately aggregate the previously mentioned factors.

With the exception of just having a general feel of volatility, there are a number of clear ways traders can read and measure volatility. One of the better known methods is through the US or EU volatility index. These markets measure the cost to own ‘put’ optionality, which will naturally increase the demand to buy downside protection. These markets also provide a guide as to the level of daily ranges traders can expect. Obviously the higher the level, the higher the implied daily move in the S&P 500 or Eurostoxx 50.

Traders can also look directly at the options market and the pricing of volatility. Buying (or being ‘long’) a ‘straddle’ or ‘strangle’ are great ways to trade volatility. To trade increasing volatility, traders can see the implied move over a specific timeframe and in the case of a ‘straddle’, one simply takes the current underlying market level (referred to as at-the-market) and find the corresponding ‘strike price’. Adding together the premium to buy a call and a put option at that same strike will highlight the implied move, so if a trader thinks the market is under-pricing volatility over a specific time frame, then being long a ‘straddle’ can be a really good way of taking advantage of an increase in volatility. On the flip side, traders can sell volatility structures as well if they feel the pricing is too high.

I would always look at the Average True Range (ATR) as well when looking at charts as part of risk and money management. The ATR simply measures the average range (the high to low) over a specific period. As a general rule, a lower time frame is better suited for short-term traders and most short-term traders would focus on the five-day ATR, although some will look at the seven-day average. The ATR is a good way of defining where to place stops and of course the higher the ATR, the further from the market the initial stop loss should be placed. Naturally the higher the ATR the more likely a trader is going be stopped out if using aggressive (or tight) stops.

In the environment we are currently seeing, traders would generally have a wider stop loss, but look to take the position size down to compensate for the larger implied moves. This works in both ways – to the stop loss and profit target. Depending on the overall strategy, traders still need to aim for a larger winning percentage than what they could have achieved on a losing trade.

These are uncertain times and for many (specifically long only traders) the worst type of action is inaction. The macro environment doesn’t look like it is going to change anytime soon, although I personally feel the market is too bearish on China at present and a December rate hike is not only under-priced but should be seen as a bullish development if it materialises. Still, until then having an understanding of volatility and how to trade it, or at least incorporate into one’s risk and money management, is fundamental in these conditions.

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