Periods of great volatility are like thunderstorms: they get your attention. For short term traders, Friday, January 28 offered a reminder of what a big volatility day feels like. Longer term investors won’t soon forget the fourth quarter of 2008 or the first quarter of 2009.
Most investors look at volatility with fear and trepidation. That view deserves merit as wild swings in price are an indication of uncertainty about the fair value of the asset in question. This uncertainty plays havoc with your bottom line as someone earning money in the markets. It is a normal tradeoff consideration to give up the potential of out-sized gains in exchange for protection against downside volatility.
In one sense, volatility is a simple concept: the greater the price swings in the shorter periods of time, the greater the volatility. At the most fundamental level, volatility is the fluctuation in the price of an asset and is an absolute requirement for a trader to make money.
Based on scholarly studies, increases in volatility correlate strongly with declines in equity value. If you look at bear markets, you see volatility everywhere, which leads to tremendous gains on up days and tremendous losses on down days. This volatility is what drives longer term investors to the sidelines and creates the window of opportunity for longer term value players to establish excellent entry points for long term holdings in beaten down companies and sectors. This eagerness to buy value at a discount is why we see buying pressure even in the midst of the worst bear markets.
Traders who are looking to make their living off the buying and selling of inventory need the volatility of longer term position traders and short term scalpers to move price in swings that last long enough for them to realize their gains while offering the buyers and sellers from other time frames reasons to get in and out of these positions as well.
Because swing traders need no confirming fundamental beliefs in their positions, they can operate successfully in swing time frames during bear markets. Provided swing traders can manage their risk in the periods of higher volatility, they should be eager to trade on the most violent of days in the market. For a swing trader, the greater the intraday volatility, the easier it is to see opportunities and frame favorable trades in terms of reward to risk.
Carefully consider the effect of volatility on your strategy and choose a measure that best meets your analysis needs dependent on your timeframe. Here are a few ways to measure volatility.
Ways to Measure Volatility
There are several different ways that traders can measure and understand volatility. Depending on the typical length of time you plan to hold your positions, you may find one of these methods more suitable for you.
The bottom line is that the method you choose should be responsive to significant changes in the time period you favor, and be sensitive enough to give you actionable information. You should be prepared to spend some time trying out different parameter settings until you find the best tradeoff between smoothness and sensitivity.
By smoothness, I mean how well the parameter settings filter out or smooth over normal noise variation in the data, yet still making it clear that an important condition in the market’s volatility has just changed.
Long term traders can simply use beta, a comparison of the asset’s volatility to that of the market’s to find out if, in general, the asset is more or less noisy than the market. I recommend considering the correlation to the market to see how much in parallel the asset will move when the market moves.
As an example: if you intend to be an intermediate to long term trader, you may be well served by considering volatility as defined by “Annualized historical volatility.” This method describes volatility as measured by the standard deviation of price for the look back period, then annualizing it using normal statistical methods. This gives us a reasonable approximation of the kind of volatility we could see over longer periods.
Intermediate term traders to swing traders (holding from months to weeks) can get good information from the simple standard deviation of price over the holding period, without a need to annualize, because you don’t intend to hold that long.
Swing traders need something a little more sensitive and reliable than standard deviation, which loses its authority to describe volatility when sample size is less than 30 periods. A swing trader would have to look at hourly price data for standard deviation to be meaningful and sometimes that data is hard to get or unreliable.
Average True Range (ATR) is probably a better volatility measure for swing traders as it is more sensitive and accurate than standard deviation in shorter time frames. By going a step further and dividing ATR by price you have ATR%, which allows you to fairly compare an asset against itself through time or to compare different assets at the same time. Plotting a time series of ATR% gives a much better representation of volatility through time than straight ATR, whose line is skewed by changes in price.
Simple ATR time series actually disguise changes in volatility. If an asset goes up in price but has exactly the same relative volatility, the ATR time series will rise, which will usually be interpreted as increasing volatility when that is absolutely not the case. Choose your graphs wisely.
To conclude, I’ll offer an analogy: volatility is like electricity, it can be your best friend or your worst nightmare. As a trader you must learn to use the power of volatility responsibly and effectively. Stay grounded and respect the power for your own good.