Pros and cons of trading volatility

In this lesson, we’re looking at the pros and cons of volatility trading, as well as how to know whether it’s for you. We’ll also explore directional versus non-directional trading and the volatility index.

Pros and cons

We’ve already mentioned that volatility can bring trading opportunities. But there are other pros and cons worth considering too. Here are some of them:

Pros:

• Larger potential for gains: As we’ve noted earlier in the course, volatile markets can offer significant opportunities due to large price swings
• Increased trading opportunities: Volatility creates more frequent and varied trading opportunities, which means traders can take advantage of short-term price fluctuations and potentially generate profits from entering into multiple trades
• Learning opportunities: When trading in a demo account, volatile markets provide a great training ground for traders looking to develop strategies that hinge on rapid price movements and uncertainty
• Dynamic trading: Volatile markets often come with increased trading volume and liquidity, allowing for faster trading, which appeals to some traders

Cons:

• Increased risk: We’ve said it before, but it bears repeating – higher volatility means higher risk. Price movements can be unpredictable, leading to greater potential for losses
• Emotional stress: While some traders thrive on the adrenaline rush of volatile markets, many others find that they are emotionally challenging. Rapid price fluctuations can trigger fear, greed, and impulsive decision-making. Traders need great discipline and emotional control to navigate volatile environments successfully
• Higher costs: Volatility can lead to increased trading costs, including:
  • wider spreads — when the difference between the bid and ask prices is larger,
  • higher slippage — the price at which your order is executed does not match the price at which it was requested, and
  • potentially higher margin requirements - the amount traders must deposit with a broker to open and maintain positions
• Increased complexity: Volatile markets can be tricky to navigate, especially for novice traders. Strategies that might work well in stable markets may not pan out in volatile ones

How do I know if trading volatility is for me?

Only you can answer that question, but here are some questions you might want to ask yourself:

• What’s my risk tolerance? Honestly assess your risk tolerance and whether or not you’re able to handle fluctuations in your account balance. If you are uncomfortable with the potential for large losses, trading volatility may not be for you
• Am I experienced enough? Volatile markets can be more challenging for novice traders, so you’ll want to develop a solid understanding of market dynamics and risk management techniques before attempting to trade volatile markets. Of course, the best way to build experience is to start trading in a demo account, where you can also test how you manage trading volatility
• Is my personality suited to trading volatility? Traders who enjoy trading volatility and who are successful at it might have personality traits that include patience, discipline, adaptability and emotional resilience. While they are able to remain calm under pressure and stick to a trading plan, they also enjoy the rush of volatility, which others might experience as stress
• Do I have the funds available and am I willing to put them at risk? Before starting to trade in volatile markets, you need to consider how much capital you have available and how much you’re willing to put at risk

Directional and non-directional trading

Directional trading and non-directional trading are two different approaches to trading that can be applied in volatile markets

Directional trading

Most traders use directional trading strategies, which involves taking a position in anticipation of the price moving in a specific direction. The aim is to profit from the overall trend or momentum in the market. Traders using trend following, breakout trading, and momentum trading strategies are all using directional trading, trying to capitalise on price movements by buying or selling assets based on the expectation that prices will continue to move in the same direction.

In volatile markets, directional traders may look to take advantage of large price swings by entering trades in the direction of the prevailing trend or momentum. Directional trading tends to be more common in volatile markets, but some traders might seek to pursue a non-directional trading strategy instead.

Non-directional trading

Non-directional trading, also known as market-neutral trading, involves strategies that aim to profit from factors other than the direction of the market. Instead of betting on price movements, non-directional traders focus on exploiting market inefficiencies, volatility changes, or relative price relationships.

Examples of non-directional trading strategies include options trading strategies, like straddles and strangles. These strategies may aim to profit from changes in volatility rather than from price movements in a specific direction.

In volatile markets, non-directional traders may seek to capitalise on increased volatility with options strategies by taking positions in both long and short assets to hedge against directional risk. For example, a straddle involves buying both a call option and a put option with the same strike price and expiration date. If volatility increases and the price of the underlying asset moves significantly, one of the options will become profitable, offsetting losses on the other option. Find out more about options trading here.

What is the volatility index?

The volatility index, aka the VIX, is a measure of market volatility and investor sentiment in the stock market. It’s based on the prices of options contracts on the S&P 500 index. Specifically, the VIX measures the expected volatility of the S&P 500 index over the next 30 days, reflecting the market's expectation of future price fluctuations, which is considered a benchmark for the broader stock market.

When the VIX is high, it indicates that investors expect significant price fluctuations in the S&P 500 index, suggesting heightened uncertainty and fear in the market. Conversely, a low VIX value suggests that investors anticipate relatively stable or muted price movements. If the VIX gives a value of greater than 30 then the market is seen as volatile, while under 20 is believed to be calm.

The VIX is used by investors, traders, and financial professionals as a tool for assessing market sentiment, managing risk, and making trading decisions. It can be traded directly through futures contracts and exchange-traded products (ETPs), allowing investors to take positions on changes in market volatility.

Trading the VIX

Trading the VIX is a strategy based on taking a view of the forming political and economic picture. VIX gains are typically a function of global instability. Trading the VIX can therefore be complex and risky, as it involves speculating on changes in market volatility, which can be highly unpredictable. Trading VIX-related products may also involve leverage, which can amplify both profits and losses.

The most direct way to trade the VIX is through VIX futures contracts. Futures contracts are a legal agreement between two parties to trade an asset at a predefined price, on a specific date in the future. VIX futures contracts allow traders to speculate on the future value of the VIX index. Traders can buy or sell VIX futures contracts with the expectation of profiting from changes in the level of market volatility. Find out more about futures contracts here and about the VIX here.