Using Volatility to Enhance Our TradingIt’s my strong view that volatility is at the absolute core of financial markets. It drives our strategy, the assets we trade, our directional bias and it affects the level of risk we take in each position, and importantly, our position size.
Hedge funds and pension funds use implied volatility as a core input, either defining how invested they are in equities, bonds and commodities, or through the use of volatility, products to track a benchmark or to enhance yield.
My view is we, as retail traders, can use the implied volatility in an instrument to trade smarter, with a view to define and enhance our risk. Rather than look at realised volatility, which is what 95% of retail traders already do, we can look forward. Implied volatility offers insight in how the market feels about all known event risk ahead of them, and how it should affect prices moves.
The options market is perfect for this, as it is based on math, and therefore, we can assess with differing degrees of confidence how far prices could move through a set period. We can apply these concepts and statistical-based moves to our spot FX, index, commodity and equity trading with great effect.
Volatility does not predict direction, but it can help us understand if the market is expecting higher or lower degrees in price moves. This can help us understand event risk far greater, and it can help us.
define our risk. This insight is useful for those running expert advisors (EA), where the performance can often be affected by the levels of volatility (vol) seen in the market. If your EA works best in a low vol environment, and you can see the market expecting higher vol, perhaps it could be advantageous to either reduce position sizing or even stay out of the market until more favourable conditions return.
I will be rolling out this spreadsheet each Monday, which looks at both realised and implied volatility and the implied moves in various instruments. I’ll explain what risk reversals are and how we can use them as a sentiment guide, as well as the weekly Commitment of Traders report, which can feed into our risk-to-reward assessment.
Register now, and even if you can’t attend you will automatically be sent the recording. For those who feel this could help improve your connection with the rhythm and feel of markets I am hoping it will be an insightful evteent.
Chris Weston, Head of Research at Pepperstone.
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