Trading: What to do when there is Volatility?

Volatility is an essential element in trading as it allows for strong price movements but at the same time carries various dangers that can put your operations and mental clarity at risk. In this sense, you must first know what volatility actually is, what happens when there is volatility and above all know how the market moves when it occurs.

Volatility is the condition in which markets start moving faster and therefore the trader’s readiness must be high, one must already know what to do under certain conditions. In this article we will explain what volatility is and how to exploit certain conditions when this situation presents itself directly in front of us when we find ourselves trading. Is volatility to be expected? What to do when there is a sharp increase in volatility?

What is volatility

By volatility we mean the condition in which market prices start moving faster and cover a high price range in a short time. In practice we clearly see a higher speed than usual and this leads to a greater range of movements. For many traders volatility is an essential condition to operate, for others represents instead a danger as it could be a dangerous situation for their own operations.

These price increases usually occur following a condition in which volatility is practically absent, i.e. price movements remain very compressed for some time and the market, in response, starts moving faster. Why does this happen? Quite simply when the market always beats the same prices, or finds itself trading within a very narrow price range, it exhausts over time the number of operators who are both on the side of the demand and on that of the offer with the consequent creation of a real emptying of counterparties.

This void causes the market to a shift in prices in search of new exchanges which, given the "congestion" phase, no longer occur on the previous levels. In practice the market deviates from the previous prices to look for new trades which, by now, will be more difficult given that there are fewer operators than before. Prices start moving fast, up or down, looking for buyers or sellers, sometimes without exchanging some prices and actually skipping some price ranges.

This "jumping" of prices leads to lower liquidity and greater volatility and in fact a real reconstitution of the market, i.e. there is a need to reform supply and demand to resume trading. Said like this it may seem complex, in reality when we see how prices move we immediately understand what volatility means.

When does volatility occur?

The increase in volatility occurs essentially in two very specific market phases. We have this increase in volatility after an extended period of congestion, which is an extended period where prices have gone on a not very steep trend where we’ve seen low volatility. In practice, after the market has found a sort of equilibrium where supply and demand often meet within a narrow price range.

When supply and demand run out, we have a strong probability of seeing an increase in volatility which takes the form of a highly directional movement or in the form of a market "squeeze", i.e. that particular condition in which the market makes what we could define as real "feints" of movement. Another condition in which we have a high probability of seeing high volatility is that relating to the release of important macro data such as, for example, data on inflation or on the decisions made regarding interest rates (be careful because the importance of the macro data obviously depends on the macroeconomic environment). The macro data offers the more volatility the more it is anomalous with respect to its target under normal conditions.

To give a real example with the current situation, we can say that if the inflation target for the major economies is at 2% and the current baseline figure is far above it, then we need to consider the macro data as a market mover. During the release of this data, the market tends to literally empty itself to make room for new orders which will depend on the outcome of the data or on market conditions, therefore very short-term conditions will be created which are literally not - negotiable and with great difficulty seeing their orders placed on the market executed at the price established by us, sometimes suffering strong splitpage (condition whereby an order is executed at a price different from the one established by us ). As we can see, these conditions are particular but absolutely decisive in both the short and long term.

What to do during periods of volatility

As mentioned before, during the volatility phases the market tends to be more "empty" than in the previous condition, therefore the first thing to do from an operational point of view is to readjust the risk of one’s strategy. If the risk is not adjusted to the new condition, there is the clear danger of carrying out operations that are absolutely not in line with the risk management we usually use, therefore it will be necessary to adjust the risk to the new market condition.

Another important thing to do is establish prices in which the trend we expect is confirmed or invalidated, prices that are obviously far from those that the market is beating. In essence it is a job of looking for levels over a longer period, for levels on higher time frames so as to look for levels that are important to the market. With regard to the time frames, we recall that the technical levels identified on the longer time frames are more valid than the levels identified on the shorter time frames. Our job therefore consists in finding significant levels on a weekly basis if we are traders who operate on a daily basis.

Obviously, as soon as there is an increase in volatility it is highly recommended to stay out of the market as it takes time to understand how volatile the market is and once the market volatility is understood and calculated, then one can proceed with operational risk adjustment.

Original article published on Money.it Italy 2022-12-15 08:57:00. Original title: Trading: cosa fare quando c’è volatilità?