Understanding volatility: causes, opportunities, and risks

In trading, volatility means quick, often unpredictable, changes in the markets. Although some markets are more volatile than others, any market can experience a degree of volatility. In volatile times, markets are generally unstable with a tendency towards sharp upward and downward moves.

In this course, we’re looking at why traders are drawn to volatility, causes of volatility (both planned and unplanned), the pros and cons of trading volatile markets and risk management.

Why do traders seek out volatility?

Volatility typically means potential for higher profits. Trading opportunities are often presented in price movements, and larger price movements mean larger potential gains. However, it’s important to remember that this also tends to mean greater risk.

Volatile markets offer more opportunities to enter and exit trades. Traders who thrive on an adrenaline rush of active markets are particularly drawn to volatile markets. Some traders also employ trading strategies that are specifically designed to take advantage of volatility, such as scalping, which can be more effective in volatile conditions.

Risk and volatility

While traders are drawn to the opportunities that volatility offer, it’s important to understand the relationship between volatility and risk.

When a market is more volatile, the potential for it to go your way increases, but the risk of the market going against you gets higher too. During these volatile periods, it’s common to see an increase in the number of trades, as well as a decrease in how long traders hold onto their positions. And, in times of extreme volatility, markets are prone to overreacting, which can mean a sudden and drastic change in the direction of certain trades. Dramatic price movements can increase the likelihood of losses for traders, which is why volatile markets are often considered riskier.

Causes of volatility

Market volatility can be divided into two broad categories: planned or unplanned volatility.

Planned volatility

Planned volatility refers to market movements that are anticipated or expected based on known events or scheduled releases. These events are typically on the economic calendar and include things like:

• economic data releases
• corporate earnings reports
• central bank announcements
• monetary policy changes

Read more about trading the news here.

Traders looking to capitalise on planned volatility will need to be prepared and to have a solid understanding of their market and the scheduled events that affect it.

Generally, trading planned volatility is considered a “trading the news” strategy because it involves basing trade decisions on scheduled events, whether that’s economic data when trading forex, earnings figures in equities, or production reports when trading commodities.

It’s also important for traders to remember that markets influence each other. So, while an economic release could devalue a particular currency, this could in turn boost specific stocks and even affect the price of certain commodities.

You need to understand which events or releases are going to potentially impact the market you are trading to best prepare yourself for that event. This might include becoming familiar with economic calendars, which provide schedules of upcoming economic data releases and other important events. Traders can use these calendars to plan their trades around key announcements and releases.

Unplanned volatility

Unplanned volatility is also known as unexpected or shock volatility. It refers to market movements that occur suddenly without any anticipation. These movements are often triggered by unforeseen events or developments and can lead to significant price swings.

Events that cause unplanned volatility might include:

• geopolitical events like wars, terrorist attacks, political unrest, or sudden changes in government policies
• external shocks like natural disasters or pandemics or
• sudden shifts in investor sentiment due to rumours, unexpected news, or changes in market dynamics
  

Trading unplanned volatility is generally considered trickier than trading planned volatility because no concrete or specific planning is possible on the trader’s part. The best one can hope for is to have a strategy in mind for what you will do in the face of unplanned volatility, and then being disciplined in implementing that should it become a reality.

This might entail :

• Keeping some capital ready: You can make the most of opportunities when they crop up if you have some funds set aside to trade. Often, traders miss out on the opportunity to trade volatility because they don’t have cash on hand
• Remaining flexible: Unplanned volatility occurs suddenly and without warning, and successful traders are those who are able to adapt and evolve their trading strategies quickly in response to changing market conditions
• Putting risk management measures in place: During periods of unplanned volatility, risk management becomes even more crucial. Traders should implement stop-loss orders, manage position sizing, and use other risk management techniques to protect against large losses during volatile market conditions (more on this in Lesson 2)
• Avoiding overreacting: While your gut instinct might be to immediately take action in the face of unplanned volatility (often, selling everything), it's essential for traders to avoid overreacting to sudden market movements caused by unplanned events. Emotional responses and knee-jerk reactions can lead to impulsive trading decisions and increased losses
• Looking for opportunities: While unplanned volatility can be challenging, it can also create trading opportunities for those who are prepared. Level-headed traders may look for oversold or overbought conditions, support and resistance levels, or other technical indicators to identify potential entry and exit points

Practice to prepare

As we note in almost every course, the best way to improve your trading and try new trading strategies – including trading volatility – is to practice in a safe environment where no real money is at risk (in other words, a demo account).

By simulating real market conditions and experimenting with different trading strategies, you can get a feel for volatile markets, and train yourself to make disciplined trading decisions in the face of rapidly changing market conditions.

In the next lesson, we’ll look at some important risk management strategies to put into place when trading volatile markets, which you can incorporate into your demo account trading.