Is volatility your friend?

Every trader knows that volatility is the thing that is necessary in order for the price to have movement. But there are different kinds of price movements. Some instruments move in fairly neat directions up, then retrace and move up again. We all love these. There are some others that are ‘all over the place’.

The chart below shows a volatile situation on 15 min time frame. Degrees of volatility seen, depend a lot on time frame. In general the lower the time frame the more chaotic is the price fluctuation. What this means is that, ‘it is a matter of perspective’.

EURAUD and EURNZD are particularly volatile between 1H and 4H charts. GBPMXN and USDZAR are by far the most extreme. In the author’s opinion, trading any of these on 15 min to 2H is pretty close to ‘gambling’ because making profits depends so much on luck. There is hardly a clearly visible trend on 15 min time frame of EURNZD below (it presents as a ranging pattern). Choppiness of the RSI on lower time frames brings out the the ‘noise’ of the volatility. On a EURNZD 1D, there is much less noise and a conspicuous trend that is for the north in EMAs. A trader would be shooting blind on a 15 min chart, as there is no clear overall trend – only microtrends that fluctuate wildly. By contrast a trader on the 1D would be building a strategy based on the trend with much less noise, though volatility is still there.

Volatility is as much a friend as the trend. Managing volatility is the key issue. When volatility is approached with a sound strategy, within the ‘envelope’ of a trend, it is more manageable. The ATR is a measure of price volatility which sound traders will be familiar with. In general most traders would look for a stop-loss that is about 2 to 3 ATRs. This means that on a 1D time frame the exposure and risk are far greater than on a 15 min time frame, as stop-losses would be much greater.

So, for a lesser more manageable volatility (on say a 1D time frame), a trader takes a greater risk of a larger stop-loss (albeit that such risks must be acceptable). In this scenario, strategy more than luck is operational. Over time, one expects that a sound strategy which manages volatility and exploits trends would show better profitability – compared to wallowing aimlessly, depending on luck in lower noisier time frames.

As this site does not give advice on how individual traders should trade, there is no comment on how the short position shown is arrived at. No claim is made that it is sound or right. The expectation at the outset is a loss, though the probability creates an expectation of a gain. Whichever way the market moves, there is expectation for gain and for loss.

The far more important issue is that individual traders develop their own methods in managing volatility.

When volatility is not well managed, there is the familiar situation where after taking an entry position, price moves against the trader – and this is followed by i.e. “Blast! Why did I enter there? I should have waited.” This is called CSW. The other emotional scenario is when price initially moves in a favoured direction, followed by a significant retracement that eats into the gain of equity but does not hit a stop-loss. This is real volatility. There is the temptation to close the position early – in profit – instead of suffering a loss. This is the emotional roller-coaster or emotional volatility if you like.

Conclusions (not advice)

1. Know the time frame.
2. Prefer time frames with less noisy volatility.
3. Manage volatility within the the envelope of a trend.
4. Volatility is your friend but friends need to be treated with respect.
5. Have a sound method that one is confident trading, based on back-testing and forward-testing.
6. Avoid hindsight bias.
7. Take reasonable acceptable stop-losses.
8. Take the loss. There is no point setting a stop-loss if one is not prepared to take the loss.

Up next: Coping with volatility.