The Importance of Understanding Volatility in Trading

[suby 10]

Often when people hear the word "Volatility" in trading they assimilate it with range or how wild something might swing. I want to start a discussion in regards to using Volatility in trend prediction (if this is even possible...).

 

The focus of this discussion will be aimed at using Volatility towards Equities and Futures (ironically not options).

 

So without further ado...

 

Who uses Volatility in their day to day trading to help them navigate the murky waters of random movements amongst Equities and Futures

 

Suby

[BlueHorseshoe 10]

Often when people hear the word "Volatility" in trading they assimilate it with range or how wild something might swing. I want to start a discussion in regards to using Volatility in trend prediction (if this is even possible...).

 

The focus of this discussion will be aimed at using Volatility towards Equities and Futures (ironically not options).

 

So without further ado...

 

Who uses Volatility in their day to day trading to help them navigate the murky waters of random movements amongst Equities and Futures

 

Suby

 

Hi Suby,

 

If people contribute this should be an interesting thread . . .

 

Here are some questions that I think might be useful:

 

1. Is volatility necessarily a function of both price and time?
    
   
2. Can volatility be classified as directional and non-directional?
    
   
3. Does volatility tend to be auto-correlated (ie does volatility beget more volatility)?
   

 

When it comes to volatility and trend, then there is a basic question to be answered, perhaps not so much about how they interact, as what aspects of their interaction are relevant to your trading goals. That sounds a bit obscure though, so here's an example of what I mean . . . A few years back I sat and read through the document in which Kaufmann describes the justification, implementation, and application for the 'Adaptive Moving Average'. Normally I'm a sucker for anything that is convincingly explained, but I clearly remember thinking "this is all wrong" at the time. Kaufmann's AMA aims to give less weight to price change when volatility is high, and more weight to price change when volatility is low. In other words, it assumes that greater volatility is a sign of increased uncertainty about an instrument's value, whereas lesser volatility signifies greater consensus about an instrument's proper value.

 

To me, this just didn't make sense. My mind ran along the lines of: "volatility means more price movement means greater participation means greater conviction in the current trend". When change is happening 'faster', I need my indicators to react more quickly.

 

Essentially, I wanted to be doing precisely the opposite of what Kaufmann's AMA does; when greater volatility entered the market I wanted to be reacting more quickly to price change, and when volatility was low and the market was lazy, I wanted my indicators to become lazy/slower/greater lookback period in response.

 

My wants are, of course, just a function of my goals. Someone with different goals may have different needs and Kaufmann's AMA might answer these. One can easily imagine that a long term trend-follower, shaken out by volatile consolidations once too often, may be interested in discounting the significance of volatile price movements within their definition of trend.

 

I hope that gives you and anyone reading some helpful things to think about.

 

BlueHorseshoe

[SIUYA 11]

it might be interesting.....

 

Remembering that there is a lot of varying ways of measuring volatility, and also its affect.

eg; in Options - volatility is usually measured historically over X days on a close to close basis.

But when it comes to that an instrument trending up by $1 every day for 60 days, produces very different results to one that moves between $98-$105 for 60 days with a $1 range each day.

 

I also think there will be a lot of ideas thrown around without a lot of evidence - and even if evidence is provided it is not applicable to every situation - like above.

 

I only used volatility in options trading and never really translated it toward straight directional trading - except to apply some rules of thumb - so unfortunately I will be full of one offs if anything in any discussion.

Blue touches on on thing that is interesting - I think the Kauffman MA makes sense, in that you might be looking for compressions in order to then look for the next range expansion - (I will investigate further )

 

As for using vol on a rule of thumb basis daily - I simply look for how an instrument has reacted recently on a "if then should basis" in that if something does not move away from a level and accelerate for me then its usually a bad sign, if something is climbing a wall of worry and showing a lot of choppy volatile movements it alerts me to look for usually a spike with the current grinds direction - followed by a reversal.....ie; little conviction, a loss covering spike or shakeout, followed by a collapse or rally. I do think that volatility does often cause more volatility as well....this might be untradeable for me though.

 

Dont know if this is much help - depends on how the discussion expands.

 

Also dragged this out from an old link i had - i dont know if it is much use....

http://quantcorner.wordpress.com/2011/12/25/historical-volatility-excel-vba/

[Colonel B 10]

Often when people hear the word "Volatility" in trading they assimilate it with range or how wild something might swing. I want to start a discussion in regards to using Volatility in trend prediction (if this is even possible...).

 

Who uses Volatility in their day to day trading to help them navigate the murky waters of random movements amongst Equities and Futures

Suby

Do you mean... Who uses those bull @#$^ volatility indicators that every one gets for free included in every major charting package like Ninja Trader? Or are you looking for people who look at ranges like Highs and lows and opens and closes and then try to place meaning to them? I use ranges but I don't use retarded indicators that the retail market uses and swears by. I am not sure if the definition is the same thing because the retail market clearly uses a different context to volatility then other traders. There are traders that think that the speed of a market is what determines the volatility. That is the tempo. This is not a huge concern because most of the time they go hand in hand. Often times the market will pick up speed and I will see some one say that the volatility went up. That could be true however its usually not. Chances are we are just trading in the same crummy range we have been for over the last 3 weeks. So speed or range? Retail or other? I am going with range in response to the question. Volatility Definition | Investopedia That is for all the QQ

 

I am not sure by what you mean by "random movements" in the futures markets. This is yet again another misconception of the retail market. I can hear the retail voices coming out already so I better clarify. Yes its true NO ONE can predict what will happen next all the time every time. There I said it. I agree with what retail believes concerning that. However just because no one can predict all the time doesn't automatically mean the opposite. It doesn't mean that they are totally random. I am sure at least 1 person will QQ and attempt to dispute it.

 

Now that is out of the way. What do I use? I use a 2 P&F for the bonds and notes, 4 for the ES, and 6 for the 6E. I also use 30 min standard Market Profile charts. Just from these types of charts you can see that I am mostly looking at ranges. I wouldn't say its the heart and soul of my operation but its inherently built in at its core. Besides the 30 min Market Profile charts I don't think I use or look at a time based chart. Who knows maybe ill switch to all volume profile charts. So all the charts I use are range charts. The over all range of the day is sometimes irrelevant to the amount of rotations in a given day. I find that no matter the range of the day that these markets still hold to the size of the rotations. Obviously large and major sudden news events will drive a market. Generally speaking scheduled news events will act as a catalyst to cause the market to do what it was already trying to do.

 

A discussion in regards to using Volatility in trend prediction... I think that Volatility the way its defined so far is the biggest key in determining trend prediction. If nothing else you can get a huge heads up. Consider you are at a weekly low. First off you need to know what the range of the week is. Hence the weekly low. I wonder how many retail traders even know where the highs and lows are and the settles and closes are for the previous day and previous week. Why is it a low in the first place? Maybe because there was a big buyer down there. Are they there the next test down? Is the weekly low the top of another range? If it is the top of another range and if the buyer isn't there then rest assured that chances are you will go down and test the low of the previous range. Just knowing these details help you to know what to look for when you get to that area and just takes out so much of the randomness. Your mind already starts to look for buyers collecting shorts. When I see the shorts get collected I get long and once that rejection happens it leaves a mark on every ones chart. Sometimes a little battle at a specific price sets the whole tone for the whole week.

 

:boxing:If you collect a few shorts at an important price and then shove it right back in their face and down their throats they will think twice about testing it again. It doesn't take a ton of them either. On the 6E its really about 300-500 and sometimes less in range and sometimes more. Today so far it was 305 and 346. Yesterdays V.A.L. is a place where tons of short term traders trade. Just like the example above... Price is coming down into an area that has meaning. You have to know that some one is going to have interest in buying there. Evey profile guy and his mom wants to get long at these prices. Is this the reason to get long too? NO!!! But when you see shorts getting collecting you have to know some one is going to get whacked. :puke: When they puked out it set the direction for a little while. It stayed in that direction till it hit the high of the day and sellers put a lid on it. It 1 time framed all the way up till the lid. Where did it turn around? Yesterdays high. Same situation in reverse. Longs got collected at the amount of 312, 346, and 600-700 farther down.

 

Who gets long the previous days high on a day like today? Or better yet who gets long 7 ticks BEFORE yesterdays high? Tons of folks I guess. Guess its "part of the plan they created that fits them" folks that I see all over the place. At least they have a day job. :shrug:

 

So hopefully that gives some explanation on a few ways I use what I consider to be volatility (ranges). I look for areas that I know will be battle areas and watch to see who is most likely going to win and try to get on the winning side.

[hackertrading 10]

The author started the post by saying that (ironically he/she does not want to consider Volatility in the Options world) - but I find it hard to understand how getting the current volatility of a stock would help you in any instrument except Options. Its the only instrument where the computation of Volatility goes into pricing of the instrument. Stocks are Futures trade in one dimension only - Price movement. That's it.

 

One definition of Volatility (and there are many) is that it represents the Standard deviation of movement from the mean. Even if you know that a stock is volatile and is at its higher end, you can probably expect a mean reversion but this still does not tell you the trend, whether its going to move up or down. The Average True Range indicator (ATR) gives you one of the best indications of how much a stock is volatile currently but this will not give you trend either.

 

In the Options world, increasing volatility generally means lower prices, and vice versa. This is helpful if you want to take a bearish position with Puts or you can play the Bear call spread, or even a Bull Put which would take advantage of a volatility crush when a reversion to mean happens.

[suby 10]

Amazed to see the quality and length of everyone's reply. I guess this is something that is on everyone's mind from one point to another.

 

In my original post I guess I should of tried to be a little bit more specific in regards to volatilities application towards helping one in predicting trend. In the tradition sense, yes volatility is useless to predict a stock/futures trend rather can only help a options trader.

 

However... Volatility can and will help each and every trader in regards to regime switching (i.e. determining whether or not something is moving within mean reversion territory or trending or entering bull/bear market territory)

 

I unfortunately do not have all the answers to this. I really do wish I could contribute more. I appreciate everyone's insight and feedback into this.

 

Suby

[hackertrading 10]

Suby, there's one thing you can do with Bollinger Bands and/or Keltner channels. By design, these indicators represent extreme points. Bollinger Bands are usually calibrated with a 2-standard deviation move on the upside as well as downside. So knowing if a stock is trading outside of these bands tells you that the stock has experienced very high volatility and is likely to undergo "mean reversion". Using this, you can take a calculated bet on the trend in the immediate future.

[SIUYA 11]

might be worth you looking at bollinger bands for some sort of compression....they are not my cup of tea but i hear they have some use.