Is Your Strategy Affected by Shifting Volatility

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Is Your Strategy Affected by Shifting Volatility?

Markets never stay the same for long. Your trading may be going very well for a time, and then all of a sudden more losing trades start popping up. You haven’t changed anything, so why will your strategy all of a sudden stop working? While it isn’t always the case, a lot of times it has to do with volatility.

Changes in volatility can have a big impact on your strategy results. If you created your strategy during a “quiet” time in the market, and it worked well, an increase in volatility could hurt you. Similarly, if you created your strategy during a volatile time, and it worked well, a decrease in volatility could hurt you.

I noticed this recently while day trading forex. Volatility has been dropping steadily in the EURUSD since late 2020 (and many other forex pairs). My day trading strategies which attempt to capture strong momentum haven’t been fairing as well, because the “pops” in price just aren’t as strong as they used to be…on average.

Figure 1. EURUSD Long-Term Volatility

Figure 1 shows average daily volatility in pips since 2020, through to April 2020. In late 2020 the average daily movement was more than 150 pips. That means if you picked a decent entry the price was likely to run a fair distance, which leaves a lot of margin for error. For binary options you can choose an expiry that is 5 minutes away or 10 minutes away and it probability isn’t going to affect performance too much since the price is moving strongly.

Progress to 2020 and the average daily movement is about 60 to 75 pips. Typically these moves are choppier and don’t run as far. And when price isn’t running, and instead moving in a move choppy fashion, that means the difference between choosing a 5 or 10 minute expiry can be the difference between profit and loss.

There is a solution. If your strategy is designed for more volatility, you may need to increase the time frame you trade on.

For me, I like day trading on a 1-minute or 5-minute chart, but recently have found much greater success trading on a 1-hour or daily chart. My trades typically last a day to three days (as opposed to 10 or 15 minutes). Notice how three days of trading at the current volatility, equals 1 day of volatility back in 2020. Therefore, by taking trades that last a day or more, I am able to capture similar amounts of volatility as seen on a daily basis in 2020.

If we start to see an increase in volatility again, I will move more focus back to trading on shorter time frames (I still do trade on shorter timeframes, just not as much).

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Traders who find success in quiet markets, like now (April, 2020), may have less success in a volatile market. They too may need to adjust their time frame in order to compensate.

The ultimate the goal is to notice when your performance is being affected by volatility, and make an adjustment for it.

It should be noted that we are looking at averages here. Just because the daily average volatility is dropping doesn’t mean we don’t see big volatility days–we do see them, on occasion.

As traders we need to be on the ball and notice how the day is shaping up. Is it going to be volatile? Are we seeing strong movements? Or is it quiet and we are seeing small movements? These types of questions will determine what type of time frame we trade on.

If you aren’t seeing relevant trends (which make trading easier) on the shorter time frame, switch to a longer one. Regardless of whether volatility increases or decreases, keep your strategies functioning by monitoring volatility and adjusting your timeframe to compensate for these volatility fluctuations.

A Momentum and Low-Volatility Switching Strategy

Changes in market volatility may be helpful for timing exposure to momentum and low-volatility funds.

A version of this article was published in the February 2020 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website.

Momentum and low volatility have been remarkably effective investment strategies, despite their simplistic focus on past performance. They are also complementary. Momentum is built to deliver market-beating returns, while low volatility reduces risk. These are both good long-term strategies, but it is possible to further improve performance by tactically shifting between the two.

3 Option Strategies To Profit In A High Volatility Market [Guestpost]

3 Option Strategies To Profit In A High Volatility Market [Guestpost]

* The following article is a guestpost. If you are an experienced trader and want to share your expertise with our readers on Tradeciety.com, check out ourВ guestpost guidelines and contact us. *

Volatility is the heart and soul of option trading. With the proper understanding of volatility and how it affects your options you can profit in any market condition. The markets and individual stocks are always adjusting from periods of low volatility to high volatility, so we need to understand how to time our option strategies.

When we talk about volatility we are referring to implied volatility. Implied volatility is forward looking and shows the “implied” movement in a stock’s future volatility. Basically, it tells you how traders think the stock will move. Implied volatility is always expressed as a percentage, non-directional and on an annual basis.

The higher the implied volatility the more people think the stock’s price will move. Stocks listed on the Dow Jones are value-stocks so a lot of movement is not expected, thus, they have a lower implied volatility. Growth stocks or small caps found on the Russell 2000, conversely, are expected to move around a lot so they carry a higher implied volatility.

When trying to decide if we are in a high volatility or low volatility market we always look towards the S&P 500 implied volatility, also known as the VIX. The average price of the VIX is 20, so anything above that number we would register as high and anything below that number we register as low.

When the VIX is above 20 we shift our focus into short options becoming net sellers of options, and we like to use a lot of short straddles and strangles, iron condors, and naked calls and put. The trick with selling options in high volatility is that you want to wait for volatility to begin to drop before placing the trades. Don’t short options as volatility is climbing. If you can be patient and wait for volatility to come in these strategies will pay off.

Short Strangles And Straddles

Short strangles and straddles involve selling a call and a put on the same underlying and expiration. The nice part about these strategies is that they are delta neutral or non-directional, so you are banking on the underlying staying within a range.

If you are running a short strangle you are selling your call and put on different strikes, both out of the money. The strangle gives you a wider range of safety. This means your underlying can move around more while still delivering you the full profit. The downside is that your profit will be limited and lower compared to a straddle and your risk will be unlimited.

To gain a higher profit but smaller range of safety you want to trade a short straddle. In this strategy you will sell your call and put on the same strike, usually at-the-money. Here you are really counting on the underlying to pin or finish at a certain price.

In both of these strategies you don’t need to hold till expiration. Once you see volatility come in your position should be showing a profit so go ahead and close out and take your winnings.

Iron Condors

If you like the idea of the short strangle but not the idea that it carries with it unlimited risk then an iron condor is your strategy. Iron condors are setup with two out of the money short vertical spreads, one on the call side and one on the put side. The iron condor will give you a wide range to profit in if the underlying remains within your strikes and it will cap your losses.

The iron condor is our go to strategy when we see high volatility start to come in. The value in the options will come out quickly and leave you with a sizable profit in a short period of time. If, however, your prediction was wrong your losses will be capped so you don’t have to worry about blowing out your portfolio.

Naked Puts And Calls

Naked puts and calls will be the easiest strategy to implement but the losses will be unlimited if you are wrong. This strategy should only be run by the more experienced option traders. If you are bullish on the underlying while volatility is high you need to sell an out-of-the-money put option. This is a neutral to bullish strategy and will profit if the underlying rises or stays the same.

If you are bearish you need to sell an out-of-the-money call option. This is a neutral to bearish strategy and will profit if the underlying falls or stays the same. Both of these strategies should use out-of-the-money options. The further you go out-of-the-money the higher the probability of success but the lower the return will be.

Conclusion

When you see volatility is high and starting to drop you need to switch your option strategy to selling options. The high volatility will keep your option price elevated and it will quickly drop as volatility begins to drop. Our favorite strategy is the iron condor followed by short strangles and straddles. Short calls and puts have their place and can be very effective but should only be run by more experienced option traders.

Want to learn more about options? Sign up and download the free option ebookВ from the author of this guestpost

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