Written by Merav Brenner, Account Manager at ORE. She has over 10 years of experience in the Futures and Options Market. Today she specializes in FX and Commodity options at ORE, a technology company creating easy solutions for FX, precious metal and WTI OIL options trading.
When trading a certain asset, buying it means you believe it will trade higher and selling means you believe it will trade lower. By placing a position, you are exposing yourself to unexpected losses in case the market trades in the opposite direction and is volatile. When placing a trade, you are required to put up margin which guarantees a limited amount of funds at risk in case the market moves against you.
You can also put a stop-loss order where you decide the amount of funds you are willing to risk. Knowingly or unknowingly, these are part of your risk management variables. To assess the probability and magnitude of a possible move against you and avoid waking up to a much greater loss than you were willing to take or a position you no longer hold because you were stopped out, you need to understand the asset’s volatility. By considering volatility you have a better chance of avoiding an unwanted surprise.
An asset’s volatility measures its price fluctuation over a certain period of time. It is not an indication of market direction. When market volatility is high it means that the asset’s price fluctuates dramatically and vice-versa is true when volatility is low, the price stabilizes. For example, in the gold market there is a clear difference between a 1% daily range and a 5% range. If the market is at $1500, a 1% daily range means that it can go up or down by $15 and 5% means it could go up or down by $75.
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With a given amount in your trading portfolio and volatility indicating a 1% daily range, you will take into account, as part of your risk calculation, the worst case scenario of a $15 move against you. If the market indicates 5% volatility you will need to readjust your stop-loss order to be able to afford a greater move against you. You may have a correct view on the market’s direction in the long-term, but if the move in your direction is volatile you might be stopped-out before your price target is reached.
So how can you assess market volatility and use it to your benefit when trading? You can do so using a financial instrument called options.
When buying options you are trading a time-limited, high leveraged product where your risk is limited to the premium paid and a crucial part of the option’s premium is based on expected market volatility. This fact opens up a world of volatility trading, educated market speculation and hedging alternatives.
In future articles we will discuss the volatility calculated through the options and the different trading possibilities.