We’re only into the second month of the year and already some traders feel like they’ve aged years trading the recent surge in market volatility. What’s that about?
What does volatility mean anyway?
Volatility refers to the amount by which an asset price fluctuates over a time period. It is measured by taking the standard deviation or the variance of price changes over a specified duration.
Woah, that’s a lot of financial mumbo-jumbo!
Simply put, volatility measures how moody the markets are. News in a not-so-volatile market environment is like your average weather report. Some might not like it, but you won’t see blood on the streets over it.
On the other hand, a volatile market environment means that positive AND negative price reactions will likely be magnified. Think reactions to Super Bowl halftime shows, a new DC movie, or an addition to the Kardashian brood.
How is volatility measured?
As discussed in the School of Pipsology, technical indicators can be used to measure volatility in the forex market. In particular, moving averages, Bollinger bands, and the Average True Range (ATR) can be used to keep track of price fluctuations.
A more common method to measure volatility is through the VIX or volatility index.
Unlike your regular stock indices, VIX combines multiple S&P500-related options prices and estimates how volatile those options will be between the current date and the option’s expiry date.
Dubbed as the “fear index,” VIX is often used to predict market volatility for the next 30 days.
Since the VIX estimates fluctuation expectations, a rising number signals increased uncertainty in markets. Meanwhile, a falling VIX usually indicates improving market confidence.
A VIX reading below 20 suggests low volatility or lower expectations for prices to fluctuate wildly. On the other hand, a VIX reading above 30 is a sign of high volatility or expectations for prices to make huge swings.
How volatile are the markets lately?
In a word, very.
The latest hullaballoo started when the January NFP report was printed. U.S. Treasury yields shot up at the same time when equity traders were pricing in (read: selling) on expectations of a more hawkish Fed monetary policy.
Volatility inevitably popped up and eventually stopped out those who shorted volatility. Of course, it didn’t help that algos further magnified the move.
Remember that while you can’t directly trade the VIX, there are a number of brokers who offer derivatives that more or less achieve the same thing.
VIX’s breakout got so bad that at one point the index traded at 50.00 before the U.S. market opened and it “normalized” to around 37.50!
How should I react to higher volatility?
As the Brits would say, keep calm and carry on. Perhaps the worst way to deal with potentially higher levels of market anxiety is to be increasingly anxious as well.
Remember that a pickup in volatility would make it even more crucial to maintain a focused mindset and keep your emotions in check.
A good way to start is by taking note of the changes in average price movements for a trading day. From there, you can make the necessary adjustments in your stops and profit targets.
An adjustment in trading style, such as shifting from longer-term to shorter-term setups, might also be appropriate.
Got any other recommendations on how to adjust to higher volatility? Let us know by dropping a comment below!