Talking Points:
- Volatility is like an aphrodisiac for traders as they treat they focus on amplitude and unconsciously assume improved probability
- Faster markets do not translate into consistency, rather the increase in market movement also comes with more likely reversals
- We consider the implications and adaptations to volatility against the backdrop of the S&P 500 and GBPUSD
How are retail traders responding to the increased volatility behind the S&P 500 and Pound-based crosses? See retail traders positioning on FX majors, indices, commodities and more on the DailyFX sentiment page.
The Fallacy of 'Volatility is Your Friend'
As a trader, I look forward to active markets. However, that is a far cry from pining after high volatility. Participation in the market is a constant effort to assess the environment and adapt to the conditions we find. And, before we can reach this state of effective evaluation and course correction, a solid foundation for investing is necessary. In addition to an established strategy, trading requires an appreciation of money and risk management. Having a well thought out plan is undeniably crucial, but the effort matters little if we don't follow our own strategy. Developing an approach to the markets is not particularly difficult. As the saying goes, there are a million ways to skin a cat. It is following our own rules to profitability (should the strategy be fruitful) or the recognition that adaptation is necessary (when it isn't) which proves most difficult for the average trader. This is struggle for most even in ideal market conditions where there is little pressure to act quickly. When volatility is added to the equation, cracks in discipline grow into explicit fissures and emotion frequently fills the gaps. The promise of a technical break in an exceptionally heavily-traded market can be a beacon to someone who has come off of a few losing trades looking to simply 'recovery the losses'. If the amplitude of a market's swings are growing wider and wider, the promise of a quick and dramatic move can encourage the bending of established rules for entry and reasonable targets in a bid for a quarter-defining, outsized trade. Volatility has a way of turning the chaste market participant to the sin of discretion and hope.
Chart of S&P 500 and VIX Volatility Index (Daily)
S&P 500 and Pound Are Ideal Case Studies of Volatility and Trading Conditions
In keeping track of market conditions across various asset classes lately, there have been a number of directional changes these past weeks and months. In fact, 2018 has proven a period prone to substantial swings with a few bouts of unchecked, fear-inducing collapse. The fevers have swept in and ultimately break, limiting the painful lessons to moderate losses that don't necessitate a systemic and self-sustaining deleveraging of risk exposure. Perhaps one of the most readily betrayed markets by the influence of volatility are US indices like the S&P 500. The famous - or infamous depending on your perspective - VIX volatility index is derived from the benchmark measure. While there productive trading in both bullish and bearish markets, the bulk of the capital market's interest remain a buy-and-hold or long-only bias. In turn, the VIX derived from S&P 500 options represents a cost of hedge to that directional skew. It is certainly not happenstance that there is a strong, negative correlation between the two measures. Naturally, this relationship can lead traders to assume a further reinforcement of direction via the two reading's correlation, but volatility also translates into a higher risk of abrupt changes in direction that betray a straight bearish run. The past month alone offers enough evidence of this break. Another remarkable example of the scourge that can arise from volatility was GBPUSD just over the past week. This benchmark exchange rate has seen significant swings pick up as the theme of Brexit have crowded the headlines. Just this past session, the seemingly switchback in fortunes for this divorce moved from promise to collapse back to promise. The volatility response was extraordinary with sharp moves and reversals. Ultimately, the wider ranges remained in place, but the volatility was difficult to miss.
Chart of GBPUSD (15 Minute)
If Not a Windfall Trend, What Kind of Trading Does High Volatility Warrant?
It would be wise to approach volatility not with a committed view of 'easy pickings' and a long run over a short period but rather as an unstable market where sudden changes in direction and tempo are more likely. The higher the volatility, the more unhinged the markets are considered - and that is just as true for general bearish trends as it is for bullish. While there is certainly a stronger correlation to markets in retreat and volatility readings rising, history does not bear out clear consistency. If we were to check our appetite for a 'home run' or 'lottery ticket' return afforded by increasingly active markets, we would be left with an appreciation for more diligently filtered trade opportunities, forgiving stops, proximate targets and time frames that do not require commitment to in long exposure where sudden turns can wipe out potential. We focus on the need to fall back on sound trading habits as volatility increases in today's Quick Take video.
