Volatility Leads to More Abrupt and Erratic Moves than Appealing Trades
- Speculators often pursue volatility assuming it will hasten their trade setup to profit
- Volatility is uncertainty imbued with explosiveness - far more risk than opportunity
- The Pound's recent activity is an obvious example, but the S&P 500/VIX combo is just as troubling
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Most traders seek out volatility, seeing it as a catalyst to hasten their projected trade setups. However, volatility at its essence reflects conditions that are both explosive and mercurial. The ideal scenario founded between technicals and fundamentals that depends on volatility boils down to a gamble on instant gratification. We should treat the unknown for the risk it implies to our trading rather than naturally presume it will supply a ready headwind and/or trend.
When volatility grows excessive, price action grows erratic. The Pound provides strong testament to that reality as of late. Heading into the EU Referendum (Brexit vote) on June 23rd, we have found implied volatility behind pairs like GBP/USD and EUR/GBP sore. In turn, we have seen sizable gaps great us on the week's open along with sharp moves intraday. This past session, the Cable soared more than 175 pips in the span of approximately a minute. The move was attributed to a 'fat finger' but a move of this magnitude in a market this liquid suggests this has more to do with market conditions. We have seen similar anticipated volatility swells leading up to the Scottish Referendum and UK General Election translate into extreme market moves. This situation looks to only further amplify these unsteady conditions.
In contrast to the obvious, high level of British Pound-based volatility measures; there is remarkable instability and thereby risk for those benchmarks whose activity measures seem to suggest all is quiet. Implied volatility readings are often good proxies for insurance against adverse market moves. The hedge is not purchased when it is most valuable - when markets are peaking and have the most to lose. When volatility surges - particularly in thin liquidity - we frequently find the most destructive market moves. At this extreme, perhaps the most recognizable undervalued risk comes from the S&P 500 and its derivative the VIX. We discuss how volatility should be treated as the risk that it represents in today's Strategy Video.
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