I’m sure you’d agree if I told you that volatility in
markets is what oxygen is to a fire, increased amounts allows for a bigger
flame but given too much and the fire
becomes uncontrollable. Judging the
latest uptick in market volatility, its key to understand the different types
that form and which of them are appropriate to trade in. So today I’m going to talk about the two
types you’ll encounter namely news and technical volatility in an effort to
make you aware of dangers you might experience if you aren’t cautious in your
approach.
Firstly it’s important to note that for any trade to work
well there is a need for volatility to be present. Attempt to trade in a
directionless market with no to low volatility and you’ll soon realise the
function it plays within the process of trading. Some of those functions are:
- Aiding the movement of prices by increasing the activity and focus around the security. Traders tend to follow big moves with loads of commentary that follows. Long drawn out price movements elicit no interest.
- Help in the formation of technical patterns that are familiar with those following technical analysis. Take the recent spurt of volatility that was able to form patterns such as the infamous Head and Shoulders or Cup and Handle; they were all formed with a degree of volatility.
Knowing this we can explore the two types of volatility that
occur in markets and how they affect your tradability as well as mental state.
So first up we have:
Technical
Volatility
This volatility happens because of the placement of orders
on both sides of the trade. There is a
balance when it comes to the sentiment a security experiences so when there is
a dominate build-up of either bulls (long side) or bears (short side). We must note that there is never a 100%
dominance of one side whether it is intraday, daily or even monthly. There are
always two opposing forces battling to make ground over the other but the one
who has the most backing being declared the winner.
However an interesting dynamic is that the title of
dominance must be tested every time the time period has ended and a new one
begins so there can be no complacency or if so the opposing force will begin to
dominate the victor and a new trend begins to take place.
Probably the most basic but effective price style available
is candlesticks popularized by Steve Nison. These price indicators contain
information which has reliable reference points to the offensive and defensive
quality of both sides.
The highs is where bulls are most optimistic and bears least
pessimistic, the lows are where the bears are most pessimistic and bulls least
optimistic. The body of the candle are
the level of intention behind the move, with a full body being associated with
high conviction and no body low conviction.
Because we know where each side lies in terms of highs and
lows, we have a degree of certainty what could happen when the price reaches
those levels. The volatility will be
found here and this is where the battle begins. So let’s run through an
example;
This is a chart of the S&P 500 Daily between Aug and
September 2015. You’ll notice the purple line is a resistance level of 1995. It
became resistance because the index lost the level in a selloff and
subsequently failed to get above it again.
We know that the bulls will be looking for ground above this point so we
make a note of this level. Lone and behold on the 17th September the
bulls make an attempt of recapturing the level.
However their attempt was foiled by the mass supply of bears
above that level that succeeded in chasing them off below that level. Going back to the point I made in a previous
paragraph, the body of the candle will tell us the intention of the winning
side, in this case the bears won emphatically.
Two points to take note of was the volume which I labelled 1
and 2 and the circled area which was the tail left behind. With the volume
notice how volume picked up from the previous days. The reason being is that so
much interest was surrounding this level that it caused a battle that resulted
in stop losses being hit. These are the orders I was referring to earlier. That
in effect increased the volume that was traded.
At the second labelled volume you’ll see a big spike in
volume, now this occurred because of traders who got on the wrong side of the
trade thinking upside was a certainty given the move but not waiting for time
period to end which would signal confirmation. As a result they got caught and
thus forced to close their trades to prevent further losses.
The circled area highlights the damaged done to the bull’s
confidence because such a long tail was left behind. This proves that the bears have taken full
control of the situation and if you follow on from that day you’ll again see
the evidence of this.
The reason I shared the example is to show how technical
volatility has a good level of predictability making it easier for us as
traders to know where to enter and exit trades as well as to paint clearer
possibilities of where the security could go which is why a trader feels more
in control when trading this volatility.
News Volatility
This type of volatility is characterised by erratic motions
in response to news flow either stemming from the security being traded or the
overall state of play in the economy. The basis of any market direction begins with
a fundamental belief that has been formulated from logical reasoning to a
series of chain reactions that may cause an increase or decrease in the value
of the stock. Various facets of news relating to the security directly or
indirectly will either support or reject the belief.
Let’s step back for a minute and try think about this for a
moment, let’s imagine the two key players driving the market as a construction
company with investors representing the engineers who meticulously plan to
minute detail how the structure (price) will be built and traders as the
construction workers who set out to laying the concrete (support &
resistance), reinforcing the structure (trend is your friend) and adding the
finishing touches (reaching new highs & lows).
However construction
work doesn’t exhibited the same level of constant productivity a normal job
entails, there’s a huge amount of stop and go as sections of the work has to be
stopped for reasons. One could be part of the process needs to be inspected to
ensure that it was correctly built before building can continue or there could
be a snag in terms of measurements. Nothing is ever perfect in life and
although the engineers spent hours calculating, 10cm is all it takes to throw
all calculations off scale.
Depending on the quality of the build or the severity of the
measurement error will determine the time it takes the engineers to rectify the
problem, the longer it takes the more downtime is at play and the more uncertain the construction workers are
about working again.
Coming back to news volatility, the same happens where
investors forecast the price a security could reach by applying research and
insight into studying figures for many hours. The traders build the price into
realising what the investors forecasted.
But think about the way each one experiences the market,
investors take a slow and steady approach knowing that there goal will
eventually be reach, their reaction time is very slow envisioning the whole
picture start to finish whereas a trader operates in short spans of time where
he finds the opportunity valid and isn’t concerned what happened weeks or even
months ago, it’s what’s happening now that’s most important.
Trader’s myopic instinct makes them susceptible to emotional
escapades when an adverse price movement snatches away vital profits at the
worst of times. This emotional
attachment often blurs reason to a point where an event that presents itself as
a potential destructor of profitability will heighten the level of emotional
response.
With the emotional barometer on the increase one can only
imagine the difficulty it must be trying to dissect, digest and react to fresh
information about a security that can have a lasting effect on the course of
direction for the security.
An explosion of different scenarios appear in the mind of a
trader once the information is made known, something which cannot be quantified
or understood in a small space of time. With a number of possibilities at hand, trade
in the security will begin to react violently as each trader imposes his/her
thought on the market, some drastic enough to eliminate key areas of technical
support or resistance points only to finish far away from any danger.
Conclusion
By trading technical patterns we are effectively identifying
patterns that repeat themselves over and over creating a better degree of
certainty for us to be comfortable with. However news is not monotonous, it’s
constantly changing as the wheels are in motion with new problems to solve. It’s
because of this reason that news volatility is more difficult to trade than
technical volatility.
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