Volatility Is Not for Sissies

Risk and volatility are two very different concepts.

Volatility is the up and down nature of markets. If your trading strategy expects the markets to move up and down, as markets often do, then you must be ready to deal with volatility each and every day. Markets trend from high volatility to low volatility and back again. While a trader does have to account for volatility when it comes to positions sizing and distance to stop losses it is not to be looked at as negative. We need prices to move in order to have trends to make profits from. Managing your trading for volatility is a better goal than choosing to dislike volatility. The biggest trends can emerge during the most volatile markets. If you risk 2% of your original capital on a particular trade, that is a real risk of capital. Controlling risk is an absolute foundation of money management. Volatility should be a source of information not stress. Volatility increases during times of uncertainty and at turning points in price. As a trend becomes established then volatility can decrease.

Volatility is not just on the downside. Markets can move in a wide price range while going both up and down. Here is one way of thinking about upside volatility: Ponder a market that is going up. You enter at $100 and the market goes to $150. Then the market drops down to $125. Is that necessarily bad? No. Because after going from $100 to $150 and then dropping back to $125, the market might then zoom up to $175. This is upside volatility in action. Volatility can be a positive thing if a market or stock is still making higher highs or lower lows as it swings back and forth inside a longer term trend.

Trend traders have greater upside volatility and less downside volatility than traditional equity indices such as the S&P 500 because they exit losing trades quickly with preset stop losses. This means they have many small loses as they constantly try to see if an entry into a market pans out into a big trend. Trend traders cap the amount of damage that volatility can do to their accounts by exiting a trade that has moved against them beyond their stop loss level. Trend traders are open to capturing a volatile trend as long as it stays inside their trending price parameters.

Michael Rulle, past-president of Graham Capital, helped to mitigate volatility fears:

“A trend follower achieves positive returns by correctly targeting market direction and minimizing the cost of this portfolio. Thus, while trend following is sometimes referred to as being ‘long volatility,’ trend followers technically do not trade volatility, although they often benefit from it.”11 The question, then, is not how to reduce volatility (you can’t control the market after all), but how to manage it through proper position sizing or money management.”

“Bottom line, you have to get used to riding the bucking bronco. Great trend traders don’t see straight up equity curves in their accounts, so you are in good company when it comes to the up and down nature of making money.”

John W. Henry made the clear distinction between volatility and risk:

“…Risk is very different from volatility. A lot of people believe there is no difference, but there’s a huge difference and I can spend an hour on that topic. Suffice it to say that we embrace both volatility and risk and, for us, risk is that we’re going to lose if we risk two tenths of one percent on a particular trade. That is, to us, real risk. Giving back a profit to you probably seems like risk; to us it seems like volatility.”

Henry’s long-term world-view didn’t avoid high volatility. The last thing he wanted to experience was volatility that forced him out of a major trend before he could make big profits. Dinesh Desai, a trend follower from the 1980s, was fond of saying that he loved volatility. Being on the right side of a volatile market was the source of his profits.

Trend trading tips:

  • Volatility can help you set your positions size.
  • Volatility can help with the placement of stop losses.
  • Some simple measures of volatility are Average True Range and the VIX.
  • Volatility is a measure of movement in a market and risk is the amount of money you can lose when a trend goes against your position.
  • You have to risk some of the open profits in a winning trade to be able to capture bigger profits in a longer term trend.