Volatility is a double-edged sword when it comes to trading. On one hand, it creates opportunities by exploiting price swings. On the other, it can pose risks if not managed properly.
Understanding the dynamics of volatility is critical for traders aiming to navigate the financial markets successfully. In this editorial, a regulated Forex and CFD broker PXBT explores the pros and cons of volatility, providing insights into its nature, the opportunities it presents, the risks it entails, and how to trade it effectively.
Advantages and disadvantages of volatility
In financial markets, volatility is the measure of price difference within a specific timeframe. It is a necessary driver of markets, helping to assess potential price fluctuations, position sizing and risk management, portfolio allocation, and investor sentiment.
Without volatility, there would be no price swings allowing for short-term trading opportunities. Volatility also encourages price discovery, helping to identify the true value of assets. The increased trading activity enhances market liquidity. Finally, volatility creates the opportunity to hedge positions and diversify a portfolio.
However, volatility also increases the risk of significant losses during price swings. It can cause significant fluctuations in portfolio value, affecting long-term investment plans. Volatility contributes to market uncertainty and psychological stress that leads to emotional trade and added anxiety for investors and traders.
How to trade volatility
There are several methods to effectively trade using volatility. The most common example is using the VIX to anticipate movements in the S&P 500. The VIX is an annualised estimate of the expected volatility in the S&P 500. To calculate an expected monthly move, divide the VIX by the square root of 12 (representing the number of months in a year). To calculate an expected daily movement, divide the monthly figure by 21 (representing the number of trading days in a month).
For individual assets, other methods can assist a trader with taking advantage of volatility. One specific tool is the Bollinger Bands, created by technical analyst John Bollinger. The tool utilises a 20-period simple moving average, with an upper and lower band set to two standard deviations. Because volatility is cyclical in nature, the Bollinger Bands can suggest when to expect volatility to increase. The Bollinger Bands tend to contract during a low volatility phase, then later expand when volatility begins to reach extremes.
To conclude, without volatility asset prices wouldn’t move and there would be no differential to exploit and take advantage of. Volatility is imperative to the price swings, small or large in size, which traders use to generate a return. Investors can buy low and sell high, while traders can go long or short to capitalise on each movement.
However, trading or investing during volatility can significantly increase market exposure. Caution is always advised when trying to take advantage of volatility, including built-in risk management tools like trading with stop loss and take profit, to avoid both trend reversals and abrupt negative movements.
Trade volatility with PXBT
Users of PXBT, an ambitious trading broker launching in 2024, can long and short a variety of Forex currencies and CFDs on Commodities and Indices like the S&P 500 – with some of the lowest fees around. The platform is built upon industry-standard MT5 technology, with plans to release a proprietary trading engine later this year.
At launch, PXBT will be fully regulated, with a tailored experience for each region. While focusing on emerging markets like Latin America and Southeast Asia, PXBT seeks to democratise trading and make professional trading tools accessible, affordable, and easy to use.
Trade market volatility with precision and ease using the accessible yet powerful trading tools provided by PXBT
Disclaimer: The information provided herein is for informational purposes only and does not constitute personal recommendation and/or investment advice. Past performance is not a reliable indicator of future results. The financial products offered by the Company are complex and come with a high risk of losing money rapidly due to leverage. These products may not be appropriate for every investor. You should carefully assess whether you understand how these leveraged products operate and whether you can tolerate the high risk of losing your money. PXBT Trading Ltd does not serve clients from Restricted Jurisdictions as listed on its website.