Volatility: it’s a subject that traders both love and fear. But there’s no need to be blindsided by sudden shifts with a little knowledge and the appropriate hedges.
First off, let’s clarify exactly what I mean by “volatility.” There are two main types that are relevant to your trading:
Factors underlying fundamental volatility include anything that can cause the price of a given trading instrument (security) to change. For example, in commodities, the most important factors are cash market supply and demand conditions. For bonds, the critical elements underlying fundamental volatility are interest rates and the credit quality of the bond issuer. Unexpected changes in any of these elements generate fundamental volatility in the instrument.
Volatility changes with time. Often, large price changes occur within very short periods of time, catching many people off guard or leaning the wrong way.
This abrupt, violent change in price movement is called transitory (or episodic) volatility and can be terrifying to the trader or investor. Those holding long positions in big drops become frightened and those holding short positions in big drops become euphoric. Since these periods of transitory volatility tend to be short-lived, only the most nimble trader is prepared to take profits from them.
For transitory volatility, the most important factor relates to impatient and uninformed traders who cause prices to diverge from fundamental values. Although such fundamental values are often not taken into consideration with technical trading techniques, it is critical for the trader to understand and exploit this deviation from what is called mean reversion. In other words, trade while the sun shines and trade what you see, but don’t think it is going to last forever, because it won’t.
What to Do About It?
Click to Enlarge Of course volatility is great when it’s on the upside. But when the market plunges down, as it did last week just before options expiration (a time when increased volatility is normal—not to mention the post-election aftereffects), suddenly volatility doesn’t look so exciting.
Here’s a hedge to counteract volatility’s bite on the downside:
Direxion Daily Small Cap Bear 3X Shares (NYSE:TZA) is a leveraged inverse ETF that trades up 3% for every 1% the iShares Russell 2000 Index (NYSE:IWM) trades down. With the recent dramatic drop in the overall markets, it’s a smart idea to have some portfolio insurance, and this is an easy vehicle to do that with.