Volatility Trading: Top 5 Volatility Strategies Explained
Welcome to our online guide on Volatility Trading – a method of trading that turns market unpredictability into opportunity. Unlike traditional methods that falter during drastic price shifts, Volatility Trading thrives amidst the chaos. Rather than betting on whether prices will rise or fall, volatility traders focus on how much the prices of financial instruments might move.
Seem a bit daunting? No worries! We’ll break down everything you need to know about this trading style, including the top 5 Volatility Strategies you can use when trading Contracts for Difference (CFDs) and any Options index so you can learn everything you need to know about Volatility Trading - even if you’re an amateur volatility trader with little to no experience. So, buckle up and prepare to learn all about Volatility Trading!
What is Volatility Trading ?
So, what exactly is Volatility Trading anyway?
Simply put, a one-of-a-kind tactic. When it comes to most trading strategies, there is one huge obstacle that serves as their ultimate kryptonite: volatility. Due to its intense unpredictability and the rapid shifts in asset prices, this market phenomenon makes the anticipation of future market movements even more challenging. Without accurate predictions, trading strategies can result in losses – defeating the very purpose of their existence.
Nevertheless, there is one trading style that is immune to volatility and stands above the rest, as it turns the enemy into a friend – Volatility Trading. Unlike strategies like Indexing that are designed to avoid volatility, Volatility Trading takes advantage of it. Instead of betting on prices going up or down (their direction) like they would when making use of the momentum trading strategies, volatility traders profit by correctly predicting significant price changes, regardless of whether those changes increase or decrease the value of their investment.
Key Takeaways
Volatility Trading is a unique tactic that profits from high market unpredictability.
Unlike other strategies that avoid volatility, it takes advantage of rapid price changes.
Volatility traders profit by correctly predicting any substantial price shifts, irrespective of direction.
Volatility Trading can be used in both the CFD and the Option index markets, but it's often seen as more suitable for the CFD market as they allow for higher leverage than Options. Therefore, we’ll be looking at Volatility Trading strategies with a particular emphasis on their suitability for the realm of CFDs. Nevertheless, Options are still crucial in Volatility Trading as they allow traders to speculate on or hedge against future changes in an asset's volatility, rather than just its price, making them another essential instrument in these types of trading strategies. So, we’ll also be keeping an eye on a suitable strategy for trading an option index!
So, are you looking for a fast-paced trading style to help you quickly profit from short-term price movements in CFDs and Options? If you are adaptable, handle risk well, and thrive on making quick decisions, then the Volatility Trading style is perfect for you!
How do I trade on Volatility?
Now that you’ve found your trading style match, you must be asking yourself: how do I trade using volatility?
“The goal of volatility trading is to capture potential profits from the expected up and down movements in the markets.”
First and foremost is understanding that Volatility Trading involves buying and selling CFDs and any option index based on dramatic price swings, and not their price direction. To do this successfully, the most important thing for you to do is understand how to measure volatility.
How do I calculate Volatility?
Volatility is the driving force and core premise of this tactic, so understanding and calculating it effectively is essential when using this trading approach.
There are several ways for you to measure CFD market volatility. A go-to-tool for many is the Volatility Index (VIX), which measures volatility in the S&P 500 Index (an index of the US stock exchange’s 500 largest companies) that shows how much stock market prices are expected to move, helping you determine the level of fear or uncertainty in the market. Although useful, the VIX index is specifically tied to the options market because it's calculated using prices of a range of S&P 500 index options. As a result, it provides traders with Anticipated Volatility, not Historical. Calculating Historical Volatility is often seen as better when trading CFDs online, as it provides a factual review of past pricing data. On the other hand, Anticipated Volatility is based on future predictions, which can be less accurate due to market uncertainties.
Therefore, when calculating volatility, there are other more preferable alternatives. For example, the Average True Range (ATR) is often a better tool than the VIX index because it specifically calculates how much an instrument's price fluctuates. This makes it more relevant for individual trades, while the VIX index is a general measure of market fear and uncertainty.
Standard Deviation
However, the best choice for calculating market volatility in the CFD market is Standard Deviation by far. It's all about measuring how far prices move away from their average price. While both the ATR and Standard Deviation measure the degree of price changes or volatility in a specific market asset, the ATR can be a less effective choice as it does not give the broader snapshot of how much risk is involved with an instrument and how much its price could change. On the other hand, Standard Deviation does this by looking at how much the returns of an investment can differ from their average return, something which the ATR does not offer.
The first step is to determine a CFD’s average price over a certain period you're interested in. Then, use Standard Deviation to see how much the price has deviated from this average.
The formula for Standard Deviation in trading is:
SD = √[ Σ (Pi - Pavg)^2 / (N - 1) ]
where:
- SD represents the Standard Deviation
- √ denotes the square root
- Σ represents the sum of the series
- Pi is the closing price of each observation
- Pavg is the average closing price
- N is the total number of observations
This formula will help you figure out how much a CFD’s closing price typically varies from its average price. It does this by:
- Finding the difference (Deviation) between the closing prices and their average.
- Squaring these deviations (multiplying them by themselves).
- The average of these squared deviations is then calculated.
- Finally, the square root of this average is determined.
High deviation means high volatility, and that's what you'd be looking for with this tactic. Remember, it's these price swings, regardless of their direction, that could potentially become profitable trading opportunities.
Advantages of Standard Deviation
1. Broad applicability: Standard Deviation can be used to measure volatility across any market, unlike ATR and the VIX index which are specific to certain markets like commodities and forex, and the US stock market, respectively.
2. Easy computation: This statistical formula is simpler to calculate than the VIX index or ATR as it requires less specialized knowledge, unlike the VIX index which demands knowledge of options pricing or the ATR which needs knowledge of an asset’s price range within specific time frames, as it is calculated using the highest and lowest prices for a certain period. Therefore, fewer data inputs are needed.
3. More accurate: Standard Deviation considers all data points to measure the spread from the mean average. It therefore provides a more accurate representation of volatility all data points are taken into account, not just price highs and lows or option index-based predictions.
Disadvantages of Standard Deviation
1. Limited scope: Standard Deviation only measures Historical Volatility (price variation based on past data) and doesn't predict future volatility (Implied). Nevertheless, Historical Volatility can still be used as a tangible, factual basis for predicting future price movements.
2. No direction indication: This statistical formula simply measures the magnitude of price movements, not their directional trends. This is not necessarily a problem when using most Volatility Trading strategies online, however, as they take into account the size of the price movement instead of the direction.
3. Sensitive to extreme values: The Standard Deviation formula is greatly affected by very high or very low numbers. The formula thus acts like a scale that tips more when there are big or small numbers, as these numbers are made even bigger when squared, large deviations, which can significantly influence the calculated average spread and lead to potentially inaccurate risk predictions.
The Top 5 Volatility Trading Strategies
Now that you understand how to calculate Standard Deviation, as well its advantages and disadvantages, it’s time to learn about the top 5 Volatility Trading strategies and get started on the road to making potential profits from these price swings!
To make use of the high volatility you need for your CFD and option index trade to thrive, you have to make use of the best strategies. Luckily for you, we’ve compiled the top 5 right here for you!
When it comes to Volatility Trading, the possibilities are endless. There's no fixed number of Volatility Trading strategies, as they can vary and evolve based on market behavior, risk tolerance, and your skill level - but there are several popular ones, especially for the CFD market.
Strong CFD Volatility Trading strategies consider factors such as: high liquidity (enabling smooth entry and exit from trades), responsiveness to global events or market news (as these can cause the quick price changes you’re looking for), and the ability to trade on both rising and falling markets. The following strategies do just that!
1. Volatility Spreads
The Volatility Spreads strategy is often considered the best Volatility tactic for CFD traders because it balances potential risks and rewards effectively. Unlike Long or Short Volatility strategies, which involve betting on an increase or decrease in price volatility, or the Long Straddle, which relies on significant price moves in any direction, Volatility Spreads involve the execution of several trades simultaneously.
The goal is to gain from the expanding “spread” - or difference between these trades - hence providing opportunities to earn in both high and low volatility scenarios. As the Volatility Spreads tactic allows for profit no matter the market conditions (making it a more versatile strategy), it contrasts with Mean Reversion, which assumes volatility will revert to its average.
In addition, Volatility Spreads also allow CFD traders to limit losses when the market is quiet, as narrower spreads mean a lower potential for larger losses.
In essence, Volatility Spreads offer a "best of both worlds" scenario - protection from big losses, and the potential for gains. This makes it a go-to strategy for many traders, especially in the unpredictable world of CFDs and the option index.
2. Long Volatility
Despite its reliance on increasing volatility, which in turn limits CFD volatility traders as opposed to Volatility Spreads which do not force traders to opt for increasing or decreasing volatility, Long Volatility can still be a highly effective strategy. This tactic, also known as going long on volatility, allows traders to profit from large price spikes and turbulence in the market, regardless of whether prices move up or down. All that must happen is a significantly large price movement – a huge increase or huge decrease.
3. Short Volatility
While Long Volatility means you're betting on major changes in prices, Short Volatility, on the other hand, means you're betting on the market staying steady or only changing a little – that volatility will decrease. So, essentially, these two Volatility Strategies are polar opposites - Long Volatility aims to make money from big swings in prices, while Short Volatility aims to make money when things stay relatively calm.
4. Long Straddle
As the name suggests, the Long Straddle strategy shares a similarity with the Long Volatility tactic – they are both suitable for highly volatile markets. This strategy is most suitable for an options index and the relevant market, as it involves buying a call option (the right to buy a certain amount of a security at a set price) and a put option (the right to sell a certain amount of a security).
If the market price swings heavily, either upward or downward, one of the options will become profitable, which helps balance the cost of the other. As a result, traders can make gains irrespective of the market direction. However, if the market remains stable, both options may expire worthless. Hence, it's a strategy best suited for highly volatile markets.
5. Volatility Mean Reversion
Finally, Volatility Mean Reversion is another popular Volatility Strategy.
CFD traders use this strategy to predict and take advantage of price changes in the market. The idea is that fluctuations in market volatility eventually return to an average level. It's like noticing that a yo-yo goes up and down, but always comes back to the hand that's swinging it. Traders can make a good guess when the market is going to swing back to the normal level, either after being really calm or really chaotic. They can then place their bets on these swings - buying when the market is unusually calm (go long) expecting it to pick up, or selling when it's too chaotic (go short), expecting it to calm down.
Out of all the other Volatility Strategies, the Volatility Mean Reversion strategy might be less popular when CFD trading online because it requires very precise timing and a deep understanding of market patterns. While the other strategies allow traders to make bets on general market movements (big changes for Long Volatility and Long Straddle, or little to no changes for Short Volatility and Volatility Spreads), Volatility Mean Reversion requires traders to correctly guess exactly when the market will return to its average level after having been very peaceful or very volatile, which may prove difficult to predict accurately for many traders.
Nevertheless, the importance of this strategy should not be overlooked.
Volatility in Forex Trading
These top Volatility Trading strategies are often used in Forex trading, which is known for its high volatility, largely due to the global nature of the market where economic events, political upheavals, or even market sentiment can cause drastic swings in currency values. From central bank decisions to geopolitical drama, such diverse factors keep the Forex market in a state of frequent and significant price movement.
Whether up or down, by making use of the Volatility Trading strategies, these movements can be opportunities for gain. In essence, the constantly changing Forex market makes the Volatility Trading strategies not just suitable for Forex, but potentially very rewarding!
Volatility in Stocks Trading
Similarly to Forex, the stock market where Shares trading takes place can also be highly volatile. Volatility Trading strategies often thrive better in the stock market. Its increased volatility, driven by rapid changes in individual stock prices, provides greater opportunities for profit compared to the forex market, which typically experiences more gradual price changes due to broader economic factors. This variation is largely due to stocks being influenced by specific company risks, industry changes, or even executives' decisions. However, the Forex market, representing entire economies, tends to absorb such shocks more evenly.
This increased rate of volatility makes the stock market, with its higher volatility, an often-better arena than the Forex market for implementing the Volatility Trading strategies, as these trading styles thrive on rapid price changes.
Conclusion
Now that we’ve delved into Volatility Trading, it's clear that there's a world of opportunity for you - even amidst the chaos of the CFD market. With the right tools, like the Standard Deviation formula, and strategies, such as Volatility Spreads, Long and Short Volatility, Long Straddle, and Volatility Mean Reversion, you've got a significant advantage.
Your insight into dramatic price changes, whether they go up or down, is a valuable tool to help you skim profits off market fluctuations. Yes, navigating this volatile landscape can be a bit daunting, but armed with these strategies and a good understanding of volatility, you're well on your way to seizing golden opportunities in the world of CFDs and the option index.
Embrace volatility: it's your pathway to greater potential profits and smarter risk management.
Welcome to our online guide on Volatility Trading – a method of trading that turns market unpredictability into opportunity. Unlike traditional methods that falter during drastic price shifts, Volatility Trading thrives amidst the chaos. Rather than betting on whether prices will rise or fall, volatility traders focus on how much the prices of financial instruments might move.
Seem a bit daunting? No worries! We’ll break down everything you need to know about this trading style, including the top 5 Volatility Strategies you can use when trading Contracts for Difference (CFDs) and any Options index so you can learn everything you need to know about Volatility Trading - even if you’re an amateur volatility trader with little to no experience. So, buckle up and prepare to learn all about Volatility Trading!
FAQs
When implementing a Volatility Trading strategy in CFD, it's important to focus on times of high market volatility. Typically, markets are volatile around major economic announcements or events like a change in interest rates, release of unemployment data, or GDP reports. These factors impact the perceived value of a nation's currency or a company's stock, causing rapid buying or selling by traders. To receive notifications and stay updated with major market events, be sure to download the easyMarkets app.
Before you start using Volatility Trading Strategies in the CFD market, make sure you understand the markets and the various factors that can influence volatility, such as economic events or market news. Additionally, setting up risk management tools, like Stop Loss and Take Profit levels, to protect your trades against sudden market movements is crucial. Lastly, it's always a good idea to practice on a demo account before trading with real money.
The easyMarkets trading platform is a great online Volatility Trading platform, offering traders unique features such as Guaranteed Stop-Loss protection, 1:2000 Leverage on MT5, and Tight Fixed Spreads. It's easy-to-use, has an intuitive trading terminal, and a wide selection of instruments - ranging from Forex and CFD trading to cryptocurrencies, all markets rich in price volatility. The platform also offers 24/5 multilingual customer support and advanced charting and analysis tools to help traders make the most of their experience.
