The idea of volatility makes many traders feel jittery and uncertain. Volatility can make traders:
1) Too frightened to place a trade
2) Panic and close a trade early
The irony is that in times of high volatility, profit targets have the best chance of being hit. Often after being frightened out of a trade, the trader will quote ‘Sod’s law’ (Murphy’s Law in America) when the market turns around and carries on in the originally forecasted direction.
The pattern of volatility
Volatility ebbs and flows in the market. The basic pattern is that the market moves from periods of high volatility to periods of low volatility. Sharp bursts of activity up or down are followed by periods of relative calm. It may be that the trend has been steady, followed by a sharp pullback – or that the trend has been fast-moving and then peters out into a steadier sideways range.
Bollinger bands are a good way to see and understand volatility, even if you don’t use them for your trading.
Chart 1: Bollinger bands on a 1hr USDJPY candlestick chart
A quick explainer: Bollinger bands are drawn 2 standard deviations away from the 20-period moving average of the price. The idea is that price will stay within the bands 95% of the time. Price is displaying unusual volatility when it is above the top Bollinger line or below the bottom Bollinger line.
Chart 1 demonstrates the idea that markets spend most of the time in periods of low volatility, with much less frequent bursts of high volatility. One logical conclusion from this is to assume low volatility, but prepare for high volatility.
How to trade with volatility
Volatility can and should be used to a trader’s advantage. It all comes back to understanding and believing in your trading system. You need to understand at what point during the ‘volatility cycle’ your trade takes place.
How to time your trade to take advantage of volatility fits into two simplified camps:
1) Place the trade during low volatility and wait for the high volatility.
The concept is placing a trade in the ‘calm before the storm’. Typically this involves trading on the pullback within a trend- or in a price range before the breakout.
2) Wait for the high volatility and place the trade once it has begun.
Typically this is the ‘breakout trade’. Here price is breaking out of a range or below a previous low in a downtrend or above the previous high in an uptrend.
If you trade during low volatility:
- Don’t close your trade for a small win or loss when volatility is still low; this approach requires patience.
- Once the volatility begins and the price moves in your favour, don’t get excited and take your profit too quickly.
If you trade during high volatility:
- Make sure to actually place the trade when volatility picks up. It is no good thinking “I’m too late” because your strategy is to wait.
- Don’t wait for a pullback once the volatility starts- the strategy assumes the volatility will continue.
“The market is too volatile right now” is often used to excuse poor trading but one of the biggest reasons for poor trading is to misunderstand how volatility works. Incorporating volatility into your understanding of your strategy can greatly improve your trading.
Jasper Lawler can be contacted at London Capital Group