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The Basics of Volatility

Aug 11, 2008
For the unseasoned trader, volatility can seem scarier than it is rewarding. Profitable traders are able to generate profits on volatile and slow markets alike, but the really big wins come from when the market gyrates up and down at a quick pace.

How to trade volatility

When the markets are on the fritz, strategies for gapping up, as well as strategies for gapping down, prove to be very profitable. Both are proven strategies that make money when the markets are uneasy because of the breakout potential that exists in a volatile market. Strategies for gapping up are only used when the markets are volatile for good reason; gaps only occur in an ever changing market. Very rarely do prices gap up in a slow moving market; by default, you could make a case that the definition of volatility is many large gaps up or down.

Finding volatility

The stock market actually has an index for gauging volatility in the market. Called the VIX, it is a measurement of how wildly the markets are trading. A higher number means greater volatility, while a lower number indicates better trending and less wild movements. Watching the VIX, along with other custom indicators tuned to volatile markets, will help produce the best results.

Volatility philosophy

It seems that traders either love or love to hate a volatile market. Traditional technical analysis tools are rendered useless when the market gyrates, as the indicators improperly value the market. Often, a highly volatile market warrants the use of watered down technical analysis indicators - that is, data over a longer period of time than would typically be used.

Improve your trading

The best way to improve your trading is to learn to trade both trending and active markets together. This usually requires that traders have a trending strategy dedicated to calm markets and trade the breakouts with strategies for gapping up or down. In the very active markets, gap ups are one of the few indicators that hold their integrity and the ability to decide direction. A gap up shows strength that the market will continue to rally, while a gap down shows the opposite.

Basic trading fundamentals should remain the same in any market; you should continue using reasonable profit/loss ratios and limit potential losses to less than a few percentage points of your trading account. A volatile market should push you to dilute your indicators with more data, expand the RSI 14 to an RSI 25, or push up moving averages to get a better view of the overall market. There is plenty of money to be made in any market with proven strategies. Be sure to properly test your trading plan before going live in a choppy market.
About the Author
Leroy Rushing is an active, professional day trader; trading coach; and author. He is the Founder and CEO of Trading EveryDay, a distinguished provider of educational trading products and services that are available worldwide. Trading EveryDay has complimentary/FREE products, a Tools of the Trade eBook and a Trading Room Report , that are downloadable for your convenience.
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