In a nutshell, volatility trading is about trading a financial instrument’s volatility instead of the price itself. As such, investors do not mind the price movements. Their main concern is how much the price will change in the future.
Are you clueless about how to trade volatility index? Do you want to learn how to profit from such trading? Read on and learn from the insights we’ll share in this quick guide.
What is Volatility?
To understand the basics of trading volatility, you must learn about volatility first. In finance, volatility refers to the dispersion of returns of a security or index. It represents the size of the price movement around a certain price.
You can also view volatility as a measure of uncertainty or risk. When the volatility is high, the value spreads out over large values. On the other hand, low volatility indicates a lack of dramatic fluctuations, showing more steady movements.
When you measure volatility, you’re measuring price changes within a specific time. If the market is volatile, the prices change quickly within a short time.
Different tools are available for trading volatility. Options are among the most popular. When traders expect higher volatility, options become more valuable in the eyes of investors.
How to Use Volatility in Trading?
Volatility trading can be intimidating for beginners. Prices are moving quickly. Hence, you must learn how to take advantage of such. A proactive approach is necessary.
Among others, one of the most important is to identify your objectives. You must be comfortable with the risks that will confront your trades. It’s also critical that you recognize the potential losses.
The right choice of assets is another crucial consideration when trading volatility. Watch out for trending stocks. Focus on entering the market before price acceleration, maximizing the benefits of such an upward trend.
In addition, you should be cautious of breakouts from consolidations. Once the price breaks resistance, consider buying. Such a breakout can signify an upward trend.
Another thing that you must do is to know when to take profits. Greed can result in huge losses. Learning when to cash out from a portion of your position is essential.
There are generally two approaches when you are trading volatility. Let’s expound on that below:
First, you can select from long volatility strategies, including the following:
- Buy calls and puts
- Bull call spread
- Long straddle
- Bear put spread
- Long strangle
Meanwhile, you can also opt for short-volatility trading approaches, including the following:
- Covered calls
- Bear call spread
- Bull put spread
- Iron condor
- Butterfly spread
Strategies for Trading Volatility
Learning how to trade volatility requires picking the right strategy. In this section, we’ll have a quick rundown of the choices you might want to consider.
It’s one of the most common strategies among volatility traders. The goal is to buy both put and call options with the same strike price and maturity. As a result, a change in the price direction will make the trade profitable.
This trading strategy’s profitability arises from the price movement’s strength in one direction. Whether it’s up or down, you can expect a profit. It’s best to implement this strategy when you expect a significant volatility increase, such as during the release of market reports.
Trading Volatility with Options
While you can trade different assets using market volatility, options are among the most popular. The options price goes up on the expansion of implied volatility, assuming all things remain equal. On the other hand, its price decrease when the volatility contracts.
One of the best strategies for volatility trading options is buying calls and puts. You can ride the wave if you believe the volatility will continue progressing. It’s when you should buy an option heading in the same direction.
Alternatively, you can also opt for a bear call spread. The strategy requires selling a call option while purchasing another call.
Volatility Stocks for Day Trading
Volatile stocks are among the favorites of day traders. One reason is that there’s a significant price movement within the day. Hence, it’s easy to enter and exit a position.
Day traders have two main options when trading volatile stocks. First, they can opt for assets with consistent volatility. Second, they can also opt for an asset that shows a significantly large price movement within the day.
While day traders usually focus on trending assets; they can also opt for volatile stocks. A larger price movement can produce a better trading outcome.
Volatility Breakout Trading Strategy
First, we must define what a breakout is. It’s a stock with a high volume but isn’t moving beyond the resistance or support level. You’ll enter a long position when the price is above resistance and a short position at the support level.
Measuring volatility breakouts require using technical indicators, such as the average true range. It indicates how much a price moves within a specific time, making it a must-have for evaluating an asset’s volatility. In turn, it can provide insights into potential trading opportunities.
Volatility Trading Indicators
Above, we mentioned that the average true range is one of the best indicators for trading volatility. Aside from such, you can also use the following:
- Relative Volatility Index: The main goal of this technical indicator is to identify the direction where a volatile asset is heading. It’s quite similar to the relative strength index. The biggest difference is that the relative volatility index uses standard deviation and not absolute prices.
- Bollinger Bands: Three bands represent this trading indicator — lower, middle, and upper. The bands expand or contract depending on market volatility.
- Keltner Channel: It uses the average true range breaking above or below to indicate a trading signal. In addition, it relies on an exponential moving average to determine the impact of price.