Understanding volatility: the key to risk management?

Traders have a Love/Hate relationship with volatility.

Not enough volatility = not enough opportunity Too much volatility = uncertain returns

Understanding volatility is a critical component of any trader's career.

Let’s dive in.

Defining volatility

Volatility is the degree of variation of a trading price series over time. Like most mathematical terms, that sounds sterile and boring. In plain English, volatility in trading is three things:

1. How much a price moves...
2. Over a period of time...
3. When compared to the average price moves over that same period of time…

Let’s grab some data to illustrate.

We’ll take a look at 253 days of price movements (average number of trading days in a year) and divide these into two data series.

• The daily price range
• The rolling average daily range over the prior 20 days

Let’s look at EURUSD:

The orange line represents the sum of the prior 20 days of prices, which we then divide by 20. This gives us a recent historical average to compare current prices to.

All things being equal, if the 20 day average daily range is 50 pips, it’s reasonable to assume that today’s daily range won’t be too far from the average. Unfortunately, all things are rarely equal,and assumptions often get us into trouble!

The blue dots are the actual daily ranges.

We can clearly see how these vary around the orange line (recent historical average).

• This variance is why “Past Performance Is Not Indicative Of Future Results” is on financial disclaimers!

The future is notoriously unpredictable.

Why look at volatility at all then? I mean, if the future is unpredictable…

It’s not about predicting the future. It’s about understanding the instrument you’re trading and trying to put things into context. For example:

Why would today be like tomorrow?

e.g.

• Today there’s hardly anything of note on the economic calendar.
• Tomorrow is US non-farm payrolls data (and everyone’s paying attention to employment).

Is volatility today likely to be the same as volatility tomorrow?

If you’re used to seeing your market trade around 50 pips each day, and it suddenly trades 150 pips in a day, things can get scary pretty fast.

Understanding volatility can help with risk management

As a novice trader, it’s tempting to oversimplify.

“I’ll use a 25 pip fixed stop on every market, keep things simple while I find my feet”

Careful. Each market has a personality. While Market A might swing 50 pips in a day on average, Market B could move 200 pips on average. 4x the volatility!

Compare fixed stops with volatility-based stops

If a trader is using a 25 pip fixed stop in a market that moves 50 pips on average each day, then their stop is 50% of the average daily range.

If a trader is using the same 25 pip fixed stop in a market that moves 200 pips on average each day, then their stop is 12.5% of the average daily range.

If a trader using fixed stops does well in the first market, but is continually stopped out in the second market, volatility might be the culprit. A stop of 100 pips might be more appropriate for the second market.

Summing up, accounting for volatility is a key element of active risk management.

Not investment advice. Past performance does not guarantee or predict future performance.