Is Your Strategy Affected by Shifting Volatility

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Is Your Strategy Affected by Shifting Volatility?

Markets never stay the same for long. Your trading may be going very well for a time, and then all of a sudden more losing trades start popping up. You haven’t changed anything, so why will your strategy all of a sudden stop working? While it isn’t always the case, a lot of times it has to do with volatility.

Changes in volatility can have a big impact on your strategy results. If you created your strategy during a “quiet” time in the market, and it worked well, an increase in volatility could hurt you. Similarly, if you created your strategy during a volatile time, and it worked well, a decrease in volatility could hurt you.

I noticed this recently while day trading forex. Volatility has been dropping steadily in the EURUSD since late 2020 (and many other forex pairs). My day trading strategies which attempt to capture strong momentum haven’t been fairing as well, because the “pops” in price just aren’t as strong as they used to be…on average.

Figure 1. EURUSD Long-Term Volatility

Figure 1 shows average daily volatility in pips since 2020, through to April 2020. In late 2020 the average daily movement was more than 150 pips. That means if you picked a decent entry the price was likely to run a fair distance, which leaves a lot of margin for error. For binary options you can choose an expiry that is 5 minutes away or 10 minutes away and it probability isn’t going to affect performance too much since the price is moving strongly.

Progress to 2020 and the average daily movement is about 60 to 75 pips. Typically these moves are choppier and don’t run as far. And when price isn’t running, and instead moving in a move choppy fashion, that means the difference between choosing a 5 or 10 minute expiry can be the difference between profit and loss.

There is a solution. If your strategy is designed for more volatility, you may need to increase the time frame you trade on.

For me, I like day trading on a 1-minute or 5-minute chart, but recently have found much greater success trading on a 1-hour or daily chart. My trades typically last a day to three days (as opposed to 10 or 15 minutes). Notice how three days of trading at the current volatility, equals 1 day of volatility back in 2020. Therefore, by taking trades that last a day or more, I am able to capture similar amounts of volatility as seen on a daily basis in 2020.

If we start to see an increase in volatility again, I will move more focus back to trading on shorter time frames (I still do trade on shorter timeframes, just not as much).

Traders who find success in quiet markets, like now (April, 2020), may have less success in a volatile market. They too may need to adjust their time frame in order to compensate.

The ultimate the goal is to notice when your performance is being affected by volatility, and make an adjustment for it.

It should be noted that we are looking at averages here. Just because the daily average volatility is dropping doesn’t mean we don’t see big volatility days–we do see them, on occasion.

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As traders we need to be on the ball and notice how the day is shaping up. Is it going to be volatile? Are we seeing strong movements? Or is it quiet and we are seeing small movements? These types of questions will determine what type of time frame we trade on.

If you aren’t seeing relevant trends (which make trading easier) on the shorter time frame, switch to a longer one. Regardless of whether volatility increases or decreases, keep your strategies functioning by monitoring volatility and adjusting your timeframe to compensate for these volatility fluctuations.

Why Volatility Is Important for Investors

The stock market can be a highly volatile place, with wide-ranging annual, quarterly, even daily swings of the Dow Jones Industrial Average. Although this volatility can present significant investment risk, when correctly harnessed, it can also generate solid returns for shrewd investors. Even when markets are choppy, crash, or surge, there can be opportunity.

Key Takeaways

  • Stock market volatility is generally associated with investment risk; however, it may also be used to lock in superior returns.
  • Volatility is most traditionally measured using the standard deviation, which indicates how tightly the price of a stock is clustered around the mean or moving average.
  • Larger standard deviations point to higher dispersions of returns as well as greater investment risk.

Volatility Defined

Strictly defined, volatility is a measure of dispersion around the mean or average return of a security. Volatility can be measured using the standard deviation, which signals how tightly the price of a stock is grouped around the mean or moving average (MA). When prices are tightly bunched together, the standard deviation is small. Contrarily, when prices are widely spread apart, the standard deviation is large.

As described by modern portfolio theory (MPT), with securities, bigger standard deviations indicate higher dispersions of returns, coupled with increased investment risk.

Market Performance and Volatility

In a 2020 report, Crestmont Research studied the historical relationship between stock market performance and volatility. For its analysis, Crestmont used the average range for each day to measure the volatility of the Standard & Poor’s 500 Index (S&P 500). Their research found that higher volatility corresponds to a higher probability of a declining market, while lower volatility corresponds to a higher probability of a rising market. Investors can use this data on long term stock market volatility to align their portfolios with the associated expected returns.

For example, as shown in the table below, when the average daily range in the S&P 500 is low (the first quartile 0 to 1%), the odds are high (about 70% monthly and 91% annually) that investors will enjoy gains of 1.5% monthly and 14.5% annually.

When the average daily range moves up to the fourth quartile (1.9 to 5%), there is a probability of a -0.8% loss for the month and a -5.1% loss for the year. The effects of volatility and risk are consistent across the spectrum.

Source: Crestmont Research

Factors Affecting Volatility

Regional and national economic factors, such as tax and interest rate policies, can significantly contribute to the directional change of the market, thereby potentially greatly influencing volatility. For example, in many countries, when a central bank sets the short-term interest rates for overnight borrowing by banks, their stock markets often violently react.

Changes in inflation trends, plus industry and sector factors, can also influence the long-term stock market trends and volatility. For example, a major weather event in a key oil-producing area can trigger increased oil prices, which in turn spikes the price of oil-related stocks.

The VIX is intended to be forward-looking, measuring the market’s expected volatility over the next 30 days.

Assessing Current Volatility in the Market

The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) detects market volatility and measures investor risk, by calculating the implied volatility (IV) in the prices of a basket of put and call options on the S&P 500 Index. A high VIX reading marks periods of higher stock market volatility, while low readings mark periods of lower volatility. Generally speaking, when the VIX rises, the S&P 500 drops, which typically signals a good time to buy stocks.

Using Options to Leverage Volatility

When volatility increases and markets panic, you can use options to take advantage of these extreme moves, or to hedge your existing positions against severe losses. When volatility is high, both in terms of the broad market and in relative terms for a specific stock, traders who are bearish on the stock may buy puts on it based on the twin premises of “buy high, sell higher,” and “the trend is your friend.”

For example, Netflix (NFLX) closed at $91.15 on January 29, 2020, a 20% decline year-to-date, after more than doubling in 2020, when it was the best performing stock in the S&P 500. Traders who are bearish on the stock can buy a $90 put (i.e. strike price of $90) on the stock expiring in June 2020. The implied volatility of this put was 53% on January 29, 2020, and it was offered at $11.40. This means that Netflix would have to decline by $12.55 or 14% from current levels before the put position becomes profitable.

This strategy is a simple but expensive one, so traders who want to reduce the cost of their long put position can either buy a further out-of-the-money put or can defray the cost of the long put position by adding a short put position at a lower price, a strategy known as a bear put spread. Continuing with the Netflix example, a trader could buy a June $80 put at $7.15, which is $4.25 or 37% cheaper than the $90 put. Or else the trader can construct a bear put spread by buying the $90 put at $11.40 and selling or writing the $80 put at $6.75 (note that the bid-ask for the June $80 put is $6.75 / $7.15), for a net cost of $4.65.

The Bottom Line

The higher level of volatility that comes with bear markets can directly impact portfolios, while adding stress to investors, as they watch the value of their portfolios plummet. This often spurs investors to rebalance their portfolio weighting between stocks and bonds, by buying more stocks, as prices fall. In this way, market volatility offers a silver lining to investors, who capitalize on the situation. (For related reading, see “How to Bet on Volatility When the VXX Expires”)

Stay Connected

Turning Currency Volatility Into A Global FX Strategy

Supply chains are globalizing even as rising protectionism threatens to place new challenges and barriers on those trade partnerships. Exposure to the risks of endless shifts of foreign exchange (FX) rates keeps executives on their toes: Deloitte recently found FX volatility to be the most common concern among surveyed corporate treasurers.

Yet understanding and developing a clear strategy for FX risk mitigation can be elusive, even for the largest firms. Studies also show that most executives agree their top challenge is market volatility and the struggle to determine when — and how — to hedge currency risk.

But foreign exchange risk mitigation goes beyond hedging, said Mark Frey, COO at Cambridge Global Payments, who told PYMNTS’ Karen Webster that, even for businesses considering FX risk for the first time, it’s never too late to make smarter decisions about their international operations.

Where companies often trip up, however, is relying on data from business that’s already been done to make those informed decisions.

“Corporates should be proactively looking at currency risk,” added Frey. “It’s not just a residual of the business they are doing — that’s the trap many organizations, and even financial entities, fall into.”

Today, however, proactive risk mitigation is much easier said than done. In a world of shifting political winds, rising protectionism and trade disputes, global uncertainty very quickly translates into FX volatility. According to Frey, the current economic climate is particularly affected by sudden policy shifts that may not necessarily be rooted in sound economic fundamentals. This can expose companies to risk, explained Frey — even firms that may assume they are immune to currency fluctuations.

A business that conducts trade with an international partner but with contracts solely denominated in the U.S. dollar (USD) may assume their company is not exposed to such foreign exchange risks. Not so, said Frey.

For instance, the appreciation of the Chinese RMB means the same USD $10 million a company may send to a Chinese business every month results in less purchasing power and leverage. Even if a business only deals in USD, fluctuations of other currencies create risk.

Other firms may assume they’re too small, or that international trade volumes are too low, to render FX risk a critical component of their operations.

According to Frey, if an exchange rate shift of more than 10 percent would negatively impact a company’s PNL (profit and loss) or ability to generate revenue, then, regardless of size, that company should deploy an FX risk mitigation strategy.

That’s because mitigation against currency volatility isn’t an isolated endeavor.

“Risk management is not in isolation from the CFO seat when it’s done well, especially for a firm significantly involved in international business,” said Frey. “It dovetails into pricing decisions — how to price products and services you ultimately sell to end customers — or where and how you negotiate contracts as a manufacturer.”

“It becomes an organizational philosophy,” he continued, “and dovetails into how you make decisions with respect to running your business across borders.”

Foreign exchange management may affect the payment terms offered to a supplier, for example, or whether a company offers credit to a business customer in the supply chain.

“Currency risk management isn’t just about executing forwards and options, selling one currency and buying another,” said Frey. “A material portion of that risk can be mitigated with the structure of pricing agreements, how you structure contracts or payment terms. You don’t necessarily have to take out financial instruments, but you can effectively mitigate risk with business agreements.”

Because FX risk mitigation touches so many aspects of the enterprise, Frey said this area is benefiting from the wave of technology adoption in sectors like accounting and treasury management. Data from these platforms is instrumental in accelerating risk analysis, Frey explained.

APIs are instrumental in pulling data from treasury management, accounting and other systems in real time and facilitating automated reports and analysis that allow for more efficient decision-making, he said. This, in turn, means companies can take a proactive stance with their FX risk management strategies — even in times of political uncertainties.

“The goal,” said Frey, “is to manage downside risk and ensure flexibility so that, in the event there are favorable risks, you’re not mitigating a favorable outcome away.”

It’s a lofty goal, and while modern technology is capable of achieving it, the market is continuously looking for other tools to provide a catch-all solution to some of the largest points of friction in FX risk management. The conversation today invariably turns to cryptocurrencies, but Frey pointed to the transaction costs, lack of liquidity of crypto assets and the even more extreme volatility of cryptocurrencies today that make such technology a less-than-stellar option for hedging and risk management — at least for now.

Instead, Cambridge is investing in country payment rails, which Frey said can “very quickly, very cost-effectively for pennies on a transaction, and with the ability to see payments in real time through a technology platform” provide the type of cross-border money movement and hedging services companies need.

“Problems won’t necessarily be solved by a crypto,” he said. “[They] will be solved by traditional rails as well.”

This document is NOT: 1) Advice of any kind, or 2) Approved or reviewed by any regulatory authority, or 3) An offer to sell or a solicitation of an offer to buy any FXIs, or to participate in any trading strategy.

“Cambridge Global Payments” is a trade name, which in this document refers specifically to one or more of these legal entities: Cambridge Mercantile Corp., Cambridge Mercantile Corp. (U.S.A.), Cambridge Mercantile Corp. (Nevada), Cambridge Mercantile (Australia) Pty. Ltd.

Cambridge Global Payments (“Cambridge”) provides this document as general market information subject to: Cambridge’s copyright, and all contract terms in place, if any, between you and the Cambridge entity you have contracted with. This document is based on sources Cambridge considers reliable, but without independent verification. Cambridge makes no guarantee of its accuracy or completeness. Cambridge is not responsible for any errors in or related to the document, or for damages arising out of any person’s reliance upon this information. All charts or graphs are from publicly available sources or proprietary data. The information in this document is subject to sudden change without notice.

Cambridge may sell to you and/or buy from you foreign exchange instruments (including spot and/or derivative transactions; both kinds are here called “FXI”s) covered by Cambridge on a principal basis.

This document is NOT: 1) Advice of any kind, or 2) Approved or reviewed by any regulatory authority, or 3) An offer to sell or a solicitation of an offer to buy any FXIs, or to participate in any trading strategy.

Before acting on this document, you must consider the appropriateness of the information, based on your objectives, needs and finances. For advice, you must contact someone independent of Cambridge.

Certain FXIs mentioned in this document may be ineligible for sale in some locations, and/or unsuitable for you. Contact your Cambridge representative for further information regarding product availability/suitability before you enter into any FXI contract.

FXIs are volatile and may cause losses. Past performance of a FXI product cannot be relied on to determine future performance.

This document is intended only for persons in Canada, the US, and Australia. This document is not intended for persons in the UK or elsewhere in the EEA. In Australia, this publication has been distributed by Cambridge Mercantile (Australia) Pty. Ltd. (ABN 85 126 642 448, AFSL 351278); for the general information of its customers (as defined in the Corporations Act 2001). This entity makes no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law.

Fees may be earned by Cambridge (and its agents) in respect of any business transacted with Cambridge.

The document is intended to be distributed in its entirety. Unless governing law permits otherwise, you must contact the applicable Cambridge if you wish to use Cambridge services to enter a transaction involving any instrument mentioned in this document.

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