Volatility trading explained
With market volatility proving critical for trader profitability, it is important to understand how it is relevant and how to trade it.
What is volatility trading?
Volatility trading is quite unlike most forms of trading, with the market representing a derivative of another market, rather than a market itself. The most popular volatility market is the Volatility Index (VIX), which is an index compiled by Chicago Board Options Exchange (CBOE) to reflect the expected volatility in the US S&P 500 market.
According to CBOE themselves, ‘the VIX estimates expected volatility by aggregating the weighted prices of the S&P 500 (SPXSM) puts and calls over a wide range of strike prices. Specifically, the prices used to calculate VIX values are midpoints of real-time SPX option bid/ask price quotations’.
Essentially, traders who speculate using the VIX will be taking an opinion on the expected volatility in the US stock market. Historically, many have labelled the VIX as the ‘fear index’, with heightened levels of expected volatility indicative of a market mentality that sees trouble ahead. Remember that historically speaking, we have only ever seen the VIX reach particularly elevated levels when there are economic issues such as the 2008 financial crisis.
How to trade volatility
There are two ways of trading volatility. Firstly, you can trade a volatility product such as the VIX. Secondly you can seek out volatility within everyday markets, with traders seeking to trade those fast moving and high yielding market moves.
VIX volatility index
Trading the VIX is largely going to centred around your perception of forthcoming economic and/or political instability. Given the economic strength seen throughout much of US President Donald Trump’s presidency, it comes as no surprise to see the initial fears gradually fade away after he took office.
However, at the turn of 2019, the VIX started to show greater sharp gains. This gives us a good opportunity to study the types of reasons why the VIX might exhibit a sharp, sustained rise.
Firstly, we have been seeing growing fears over the future economic stability of the US, as exhibited by an inversion of the yield curve. A flat or inverted yield curve signifies an environment where traders are somewhat fearful for the future, if not the immediate picture.
What are the most volatile markets?
There are a number of ways to search for volatility within financial markets. Some markets inherently exhibit higher average daily movements when measured in pips, while others will generally move few points in a day.
A perfect example of this is the Dow Jones, compared with the S&P 500. Given the relative value of each market, it makes sense that traders will see substantially larger movement in terms of points or ticks for the Dow - currently around 23,000. Which is in comparison to the S&P 500, currently around 2500.
This accounts for much of the reason why even within the UK, the DAX is often a more popular market for traders than the FTSE 100. In terms of index pricing, the FTSE 100 is around 55% smaller than the DAX. However, they also provide a good example of two markets that typically exhibit a significantly different amount of volatility, which outstrips the differentials in terms of index pricing.
The weekly 14-period average true range (ATR) – a volatility indicator – for the FTSE 100 peaked around 280 in early 2016, while the DAX peaked around 600 at a similar time. That means that while the DAX is valued at 55% more than the FTSE 100, we actually see price swings that would be associated with a market that is 114% larger.
How to calculate volatility
The example above highlights one of the more popular indicators used to calculate volatility. The ATR provides an indication of the average range of price action, typically for 14 periods of any given timeframe. Of course, traders also adjust that default setting to reflect shorter or longer-term averages. For example, if you look at the one-day ATR, that will show you the range for each day of trading.
Alternatively, if you look at the 14-week ATR, it will give you less of an idea of any single day moves, and more an idea over what the average is over the past three months. The utilisation of the ATR is useful since it provides a historical context to the volatility reading, with traders able to garner an understanding of whether that range is the norm or atypical.
A good way of highlighting the usefulness of the ATR comes when looking at two similar markets. The Dow and the DAX are both typically chosen for their oversized market moves, yet we are seeing a significant shift during Trump’s reign, as highlighted by the ATR. Back in 2014, the DAX was seeing a weekly ATR high of 390, while the Dow ATR peaked at 420. So, while the Dow volatility was marginally higher, it was not a particularly significant amount to dictate which you would trade. Fast-forward to the present day, and we have a Dow ATR of over 1000, while the DAX figure is closer to 450. Therefore, it makes sense for a volatility trader to look towards the US index rather than the German market.
Volatility trading strategies
Trading either volatile markets or the VIX would obviously require different approaches from a trader.
VIX volatility trading strategy
Trading the VIX is very much based on taking a view of the forming political and economic picture. VIX gains are typically a function of global instability, which is also reflected by alternative markets. Examples of this include the yield curve and the value of havens.
The yield curve in particular can prove invaluable for VIX traders, with falling long-term yields and rising short-term yields synonymous with a growing fear within markets. This is driving investors towards locking in long-term returns in the bond market rather than allocating their assets into riskier instruments like stocks. Given that market sell-offs tend to be volatile in nature, an inverted yield curve can be used as a means to look for a higher VIX and lower stocks.
Volatile markets trading strategy
Trading volatile markets is a different challenge, as this can happen on any market. Of course, each market has its own idiosyncrasies and driving forces behind why it might be moving. However, when it comes to trading around volatility, traders can utilise a number of techniques irrespective of the market itself.
One of the precursors to volatility can be when we see price action tightening, with the Bollinger Band shrinking to highlight that fall in volatility. However, such an occurrence can act as a precursor to a sharp rise in volatility and thus traders can await a sharp breakout out of the Bollinger Band to spark a surge in directional movement.
The WTI chart below highlights this in action. The top left part of the chart shows a market with low volatility, as exemplified by the narrow Bollinger Bands. However, with a sharp breakdown in early March came a ramp up in volatility, sparking a downtrend. On this occasion, a short position on that breakdown, with a stop-loss above the prior high of $55.05.
Finally, there will always be a number of approaches to trading a volatile market. Ultimately, it makes sense to look out for directional volatility rather than unpredictable volatility. With heightened directional volatility, traders will need to ensure their losses are minimised and that allows the profitable trades to far outweigh the losers.