Use Volatility To Your Advantage
When we think about equity markets, the first word that comes to any investor's mind is “volatile”. The most common reason why a lot of investors avoid participating in equity markets is because they cannot handle the volatile nature of equity markets on their own. The outcome of not being able to manage volatility properly in equity markets is that the investor experiences huge losses in the markets and eventually gives up on the asset class itself.
Matured investors do not chase returns and evaluate stocks on risk-adjusted returns basis. Volatility (riskiness) is almost always factored in while making investment decisions by matured investors. Majority of investors do not factor in volatility and hence are taken aback when suddenly the stock prices tumble. Says Mrinal Roy, “I have been in markets for more than a decade now, but I have never understood how to read volatility in markets. Almost always I have been caught on the wrong foot. Whenever I thought prices will be less volatile , the volatility jumped higher and vice versa. I wish I had skills good enough to read the market volatility so that I could build my positions using the insights.”
What is volatility and which tool indicators can be used to profit from volatility?
There is a well-known adage: In order to make money in the stock markets, there must be price movement! Fortunately, price movement is a constant in the markets. However, the degree at which prices move varies. Sometimes the tone of the market is relatively quiet, while there are times when prices move at an above average speed. In simple terms, volatility can be described as ‘the speed at which price movements occur’.
Just as a coin has two sides, volatility also has two sides; first, it provides opportunity to make more money, while on the flip side, it increases the risk as well.
The objective for any investor or trader is to beat the volatility by managing it in such a way that one optimises the returns on the investments. Technical analysis surely plays an important role when it comes to managing volatility so as to make profit from increased volatility. Different chartists bet on different techniques and indicators to beat volatility. Says Raju Ranjan, Sr. Technical Analyst, Definedge Solutions, “ We primary use the point & figure charts for our trading with a default reversal value of 3-boxes. The P&F charts have the inbuilt structure to accommodate volatility and reduce a lot of unwarranted trades that end up being a whipsaw.
When volatility increases in a trending phase, then P&F signals will ensure that you can participate, may be with a lower position size if need be. In a non-trending volatile environment, where the price is gyrating within a range, the P&F charts are helpful in reducing the number of trades and thereby ensuring lower drawdown.”
There are a few more indicators which the chartist swears by such as Average True Range (ATR). ATR as an indicator can be used in volatile markets. The ATR is a volatility-based technical indicator introduced by the J. Welles Wilder in his 1974 book “New Concepts in Technical Trading System”. The indicator helps an active trader to gauge how much the price of an asset moves on an average over a given time period.
ATR : As an indicator to gauge volatility
ATR indicator does not give buy or sell signals. It is a tool that is used in conjunction with a strategy to help filter trades. It does not necessarily predict anything, but it helps to determine the volatility of the stock. When the ATR is falling, it is an indication that volatility of the security is on the decline, whereas when the ATR shoots up, it is an indication that volatility has been on the rise.
In the Reliance Industries chart below, we have shown ATR at the bottom and the price movement of the stock is shown on the top. If you check when ATR was moving at turtle’s pace, it clearly depicts that the stock was in a consolidation or it traded in a range-bound manner. However, after February 2017, ATR started increasing which indicated that the stock was likely to give trending momentum.
ATR: FOR STOCK SELECTION
The nature of volatility is cyclical, it rises and falls. It moves from a period of low volatility to high volatility, and vice versa. This means that when the market is in a low volatility period, we can expect volatility to pick up soon. By using this concept, we can find some explosive breakout trades before it occurs.
As in the intraday chart of Havells India Ltd given above, the stock is trading in a narrow range for two days. The volatility is getting squeezed and the ATR reached near the recent low. Thereafter, we have witnessed explosive breakout in price.
ATR: FOR PROFIT-BOOKING
Profit-booking is the most important part of short term trading. It is not our entries where we make a profit or loss, it is our exits.
For profit-booking, ATR works like the fuel indicator in a car. The fuel indicator in car tells us how much fuel is left in our car. If we know the mileage (average kilometre per litre) of our car, we can figure out how far we can travel without running out of fuel. Similarly, the ATR helps us to understand profit potential of our trade.
Daily ATR gives us the average daily range of that particular stock. By using this, we can easily calculate the profit-booking levels. ATR tells us exactly how far we can expect a price to move on any given day based on the recent price movement.
For example, on February 6, 2019, Nifty gave a range breakout at 10980, and after the breakout, the price moved higher as expected. If someone has to check the expected upside target of Nifty, he has to add ATR(14) in the low of that day and he will get the upside target for Nifty.
121.15+10964.40= 11085.55. On that day, Nifty made a high of 11072, which is near about the ATR target.
ATR: AS VOLATILITY-BASED STOP LOSS OR TRAILING STOP LOSS
Many traders use normal support levels defined by a demand zone to set up stop losses. However, in this method, many of the traders ignore the speed of volatility, hence, using ATR to set-up stop losses is the way the professionals and the algorithmic traders follow. If your stop loss is too tight, you may get out of the trade before price moves in the direction you actually wanted it to move, and if your stop loss is too wide, then you run the risk of booking a much larger loss than you might want. ATR provides the solution to this problem. We can easily calculate the stop loss using the average volatility. The commonly used technique for placing stop loss is using the multiple of the ATR. Two is a common multiplier for aggressive traders and three is for conservative traders. If we are in long position and the price moves favourably, then the High-(2*ATR) will be the trailing stop loss.
Head of Research, DealMoney Securities Pvt (formerly Destimoney Securities Pvt Ltd).
" In A High Volatility Environment, Long Term Investors Should Stay Away From The Markets"
How does one deal with the higher volatility?
Volatility in the Indian markets is often tracked by Volatility Index (VIX). It is also known as Fear Index and measures the expected volatility of market participants. Higher volatility generally occurs when there is a fear and uncertainty in the markets. Higher volatility is not good for anyone; however, there are some professional traders who mint good money in high volatility markets. There is always a thrill among traders when it comes to higher volatility because it always attracts by giving quick money, but as the same time it increases your risk too. With respect to dealing with a high volatility environment, I suggest long term Investor to stay away from the markets and not to try averaging the losing position, whereas a newbie should either stay away or should reduce his position size and trade in smaller quantities but follow strict stop loss to protect his capital.
It is always said that huge spike in volatility means opportunities are on the rise and so is market risk. Hence, would you suggest any rules that our readers should follow to reduce risk during high volatile times?
I don’t believe high volatility is an opportunity in the markets for everyone. It is definitely an opportunity for professional option traders, but not for everyone. High volatility indicates high level of uncertainty and fear in markets. Ideally one should not invest in a market scenario where there is lot of uncertainty. Hence, I would recommend investors to wait till volatility subsides and the event due to which the volatility was increasing gets completed in a smooth manner. For an amateur trader, I reiterate that you should trade in smaller quantity with a strict stop loss.
What are the ways a trader or investor can take advantage of high volatility?
High volatility gives the opportunity for high frequency traders or option traders who want to trade on every move, but for investors, I would say they should prefer to stay away. Option trader can do various derivative strategies having low risk (i.e. limited risk and reward payoff) which involves selling volatility. Professional trader trades volatility on both the side through derivative strategies, i.e. they try to take a view and forecast the implied volatility of option and create option strategies which gives profits if volatility increases or decreases.
The Volatility Index (VIX), a.k.a ‘The Fear Gauge’' is a sentiment indicator that helps determine the market expectations from the near term volatility, which is assumed to be the next 30-day period based on the option prices of Nifty. It acts like a thermometer for the market. The value of the VIX rises with a rise in volatility. Volatility is often described as “the rate and magnitude of changes in prices” .
VIX was first introduced by the Chicago Board of Options and Exchange (CBOE) as the volatility index for the US markets in 1993. In 2003, the methodology was revised and a new volatility index based on S&P 500 options was introduced. CBOE also introduced VIX futures in 2004 and options in 2006.
India VIX uses the computation methodology of CBOE, with suitable amendments to adapt to the Nifty options order book using cubic splines methodology, etc. India VIX derivatives can be used for portfolio diversification, volatility trading and hedging.
The India VIX is computed by NSE based on the order book of Nifty Options. The best bid-ask quotes of near and next-month Nifty options contracts which are traded in the F&O segment of NSE are used for computation of India VIX.
VIX helps fundamental investors gauge the volatility in the markets and time their entries and exits into stocks in order to take advantage of mispricing opportunities. A period of very low volatility is generally followed by a period of high volatility. A period of unusually low volatility could indicate potential overvaluation and vice versa.
Traders use the VIX to take advantage of moneymaking opportunities and hedging strategies due to extreme market sentiment. Traders can use the VIX index charts using technical analysis techniques like Bollinger bands, 200-day moving average, etc. combined with various derivative strategies. ATR is one of the many indicators that can be used to profit from volatility in the markets.
Success in the stock market looks unlikely if the trader or investor fails to understand and manage the volatility of markets. Ignoring volatility can be suicidal for both investors and traders. On the other hand, understanding volatility and gaining the ability to ascertain the underlying trend using VIX can prove to be extremely profitable.
Volatility can be your friend if you want it to be. Volatility is not inherently bad for you if you are a skilled trader or an investor. Technical analysis may be the key to successfully tackling the increased volatility in the markets. It is essential that traders/ investors develop expertise in tracking particular tools/ indicators such as Point and Figure, ATR , Bollinger Bands, etc., so that money can be made in volatile markets as well. A well-devised trading plan should incorporate the expected volatility of the underlying security or index. In our view, to read the volatility in the markets, it is essential to track, understand and interpret VIX, Bollinger Band and ATR. An accurate reading of these three tools will not only help investors and traders protect their losses, but will also help them book profits in difficult (volatile) times.