Volatility, or price variability, is identified by rapid fluctuations in both bullish (up) and bearish (down) price action. When developing a futures trading plan, futures traders should account for times of increased volatility.
By understanding how volatility works, you can better prepare yourself for rapid price swings and determine whether opportunities exist within your risk tolerance.
Is Volatility Beneficial for Traders?
Volatility is inherent in speculative markets and typically occurs based on an imbalance in sentiment. That is, when the market is strongly biased in one direction, an increased number of buyers or sellers can create sudden and unexpected price movements.
- On the positive side, volatility indicates an active market and can create trade opportunities. In fact, too low of volatility can create sideways markets which minimize trading prospects. In other words, if there is no volatility, markets do not move enough to trade.
- On the other hand, high volatility is a symptom of an unbalanced market and can cause panic and added risk. Traders should not only know how to identify volatility spikes as they occur, but also take additional precautions during times of elevated volatility.
It is important to distinguish volatility from risk since they are not the same. Like many other aspects of trading, how volatility impacts you will largely depend on your risk tolerance and trading methodology.
Use a Larger Timeframe to Put Things in Perspective
While active day traders might associate increased volatility with risk, longer timeframe traders might brush off intraday volatility as just noise. In the example below, notice how volatility can be assessed differently using different timeframes.
For example, in the hourly Nasdaq futures chart below, a significant amount of price variability can be seen. Shorter timeframe traders might have considered this price action to be volatile and could have been shaken out of positions on both sides of the market due to rapid price swings.
Putting things in perspective, the entire chart above is represented by the yellow rectangle in the daily Nasdaq futures chart below. To traders of larger timeframes, intraday volatility seems less significant and the uptrend remains intact. Therefore, using a larger timeframe can help provide “the bigger picture” of a current trend.
Tips for Trading During High Volatility
Remember that volatility is inevitable in futures markets and it is the very nature of markets to move up and down based on participant speculation.
Ultimately, how you approach volatility will largely depend on your timeframe, market approach and individual methodology. With that in mind, below are some general recommendations for times during increased volatility.
- Know your risk tolerance. Having a realistic risk tolerance is essential to a balanced trading methodology and will help you identify when markets are potentially “too volatile” to trade.
- Use protective stop-loss orders to manage risk. Understanding the different types of stop-loss orders and when to best employ each is critical to trading during increased volatility.
- Understand your futures margin requirements for the contract(s) you trade. This is a critical component of futures trading and position management.
- Generally speaking, new futures traders should consider extremely volatile market conditions to be unfavorable for live trading.
- However, volatile markets can create great opportunities for new traders to practice paper trading to help understand which market conditions produce the most consistent results.
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