Volatility trading

Through understanding volatility, you can create appropriate trading strategies​ that help to harness profit potential. This can be done by trading volatile assets, tracking changes in volatility to aid in selection, incorporating volatility-based technical indicators or software, or by focusing on low-volatility assets.

Volatility is an important metric for all traders, including short-term day traders and swings traders, whose primary focus is on daily and weekly price movements.

So, how is volatility traded? You can trade on volatility across various markets and timeframes. In this article, we will look at volatility trading strategies that can be applied to shares, forex and commodities.

As we have discussed, the average true range is a particularly effective tool for tracking how much an asset is moving, on average, for each price bar.

Historical volatility also measures price action. This is a technical indicator that is shown below on the EUR/USD chart. Implied volatility anticipates what could happen in the future. For example, historical volatility may be low, yet we know that if the US Federal Reserve or the Bank of England releases an interest rate announcement, this will cause increased price movement and volatility in the forex market. Implied volatility is derived from the options market, where put and call options are bought and sold.

The Relative Volatility Index (RVI) is another indicator that analyses the direction and volatility of price. It is the bottom indicator shown on the EUR/USD chart below. When the indicator is above a level of 50, this means that volatility is on the upside. When the indicator is below 50, this means that volatility is on the downside. Therefore, if a buy signal occurs and the indicator is above or passing above 50, this helps to confirm the buy signal. If a sell signal occurs and the indicator is below or passing below 50, this helps to confirm the sell signal. It is not reliable as an indicator when only used by itself, but can be used to confirm entries in conjunction with other strategies.

The CBOE VIX index is an instrument that measures market volatility (how quickly prices are likely to change) over a period of 30 days. Traders can use it to assess market risk, which is why it’s sometimes referred to as ‘the fear index’. It averages the weighted prices of S&P 500 options. Learn more about the VIX volatility index​.

Quantitative volatility trading uses computer programs and algorithms to exploit changes in volatility. The use of software means that a strategy can be implemented on much shorter timeframes, or more trades can be taken than what is possible for a human. For example, a computer could place trades in milliseconds, potentially placing hundreds or thousands of trades per day for tiny profits, using a variation of the strategies discussed earlier. Read more about quant trading strategies.

We host the international trading platform, MetaTrader 4, through our own software. MT4 is available to customise and provides a wide array of indicators to track and anticipate volatility changes. In addition, MT4 also supports automated trading solutions called Expert Advisors, which are computer programs that trade on your behalf. Learn more about MT4 trading here or register for an account now.

The UK's no1 web trading platform​, Next Generation, offers a number of volatility indicators required to trade the strategies discussed, as demonstrated in the above charts. The platform comes with drawing tools, price projection tools and chart forums so that traders can display their data clearly and easily.

Open a live account now to get started trading on volatility. This comes with a free demo account that allows to you practise with virtual funds before depositing real money.

When trading volatility on our platform, we require traders to trade on margin. Leveraged products​ have the potential for larger profits, but equally large losses. For example, if an unleveraged EUR/USD position moves 1% or an unleveraged stock position moves 1%, the trader makes or loses 1%. However, say that the trader uses a leverage ratio of 10:1 on that position. Now, that 1% move turns into a 10% potential profit or loss.

The above filters out volatility. The price was moving 1% on average, but consider that now it is moving 5%. With the same 10:1 leverage ratio, holding through a 5% price swing could mean a 50% profit or loss on the position.

While traders like the chances of increased profits, opening an unsuccessful trade using leverage can be catastrophic, and volatility increases the magnitude of the problem. For this reason, you should always trade with a stop-loss or exit point in mind.

Trading volatile markets and price movements does not appeal to all traders. Most long-term investors prefer markets to be quiet. However, day traders can take advantage of low volatility by acting like a market maker — someone who provides buy and sell orders when needed to help create a liquid market. They make their money by buying lower and selling at higher prices throughout the day.

An example would be a $0.01 stock that does not fluctuate much in price but has buyers and sellers at $0.03 and $0.035. A trader could place a bid at $0.03 and a sell order at $0.035. If both their orders fill, they make 16.6% without the price even moving. In price terms, this is not a particularly volatile stock, but in percentage terms, it is, because each $0.005 move is a big percentage jump. Read more about trading volatile UK penny stocks.

Volatility trading has the potential to provide big rewards when using leverage, but also big losses. Whether trading a volatile market or not, risk management​ is paramount. Stop-loss orders should always be used, and the need for these execution tools increases as volatility and/or leverage increases.