Is Volatility Important in Trading?

In the last several weeks there has been lots of talk (at least among traders in my orbit) about the small intraday ranges in the S&P 500 e-mini futures contract.  Yes, volatility in the stock index futures has been subdued lately, largely due to the fact that three of the major averages (S&P 500, the Nasdaq and Russell 2000) recently breached their all-time highs.

Generally, an upward trending market suppresses volatility as markets tend to move at a slower pace to the upside than they do to the downside. In fact, studies have shown that the stock market falls three times faster than it rises. There are two main reasons attributable to the faster movement of the stock market falling; namely that, fear is a much more powerful emotion than greed and the majority of participants in the stock market own shares, and thus, when they begin to get scared and start selling the result is a steep decline as there are few buyers left to prop up prices when the selling begins to accelerate. A basic understanding of market dynamics, where every order has to be matched explains this phenomenon.

Traders use various indicators to gauge volatility, but the most popular is (appropriately named) the CBOE volatility index, or VIX.  This index is simply a measure of the implied volatility for options (puts and calls) in the S&P 500 that will expire in 30 days. Some on Wall Street also refer to this index as the fear gauge as it can be a good measure of how investors are feeling about risk.

If investors are feeling risk averse they will buy put options, which give them the right to sell their shares for a predefined price at a predetermined date. These act essentially like an insurance policy for their holdings. So, as the market declines the demand for puts increases, and that in turn pushes the VIX higher.

Historically, levels under 15 in the VIX have indicated a general sense of complacency since premiums are very low suggesting that investors do not feel the need to pay for insurance. On the flip side, readings over 40 historically come after lots of selling and when fear is rampant.  This is where the demand for put options is the heaviest and premiums are very inflated.

One of the many misconceptions of the VIX index is that a low reading in this index implies that the market is due for a big selloff.  Conversely, many traders have been conditioned to think that a VIX above 40 implies that a bottom is near. The fact is that since this index was introduced in the early nineties, there have been many instances where the VIX spent many months in the low double digits and the market continued in its upward trajectory.  This has been the case in the last 9 years.

In the height of the financial crisis, when we were on the precipice of a financial meltdown and the S&P was down over 50%,  all the previous high readings in the VIX were shattered as the index hit a jaw-dropping high of 89.53 on October 24 2008. Incidentally, even after such a high reading in the fear gauge, the decline in the market continued until March 9th of 2009 when the S&P 500 finally bottomed.

For traders focusing on the stock index futures, the lack of volatility simply means that they have to be more patient in picking their spots of entry because the profit margins (the distance between supply and demand levels) are generally smaller in this type of environment.  The beauty of trading futures, however, is that there are plenty of other markets that are non-correlated and have little to do with the volatility of the stock market.

So, does volatility matter?  I guess the answer is yes in one respect and no in another. On one hand, the more volatility in a market, the bigger the moves and the greater the opportunities. On the other, less movement means smaller profits and more patience.

Another way to look at volatility is that for the skilled trader, one that has the discipline to execute a low-risk proven strategy, big movement in the market looks like opportunity.  For those that don’t have discipline, or a viable low-risk strategy, trading in a volatile market can be disastrous.

The question for you as a trader reading this article is:  Does volatility conjure up emotions of fear and uncertainty, or does it open up the possibility for plenty of profit opportunity?

Until next time, I hope everyone has a great week.

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