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Five Reasons Why Traders Love Market Volatility

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November 5, 2015
Traders love stock market volatility

Many investors bristle at the notion of market volatility. Most active traders embrace it.

Each trader knows what drives him or her personally to jump into the glorious chaos every day (or most days). But, collectively, here’s why most individual active traders—and an industry of traders—love market volatility.

1. Action, Jackson. Volatile markets are characterized by wide price fluctuations and heavy trading. They often result from an imbalance of trade orders in one direction (for example, all buys and no sells). Triggers might include economic releases, a company bombshell, a recommendation from a well-known analyst, a much-hyped initial public offering (IPO), unexpected earnings results, or the risk of global financial ripples. Some market observers “blame” undue volatility on day traders, short sellers, and institutional investors whose buying and selling wake might capsize the little guy.

For most traders, volatility doesn’t necessarily distort the true health of a market. That’s because they believe that whatever the market dictates is the true health of the market. Exploring risk management and embracing volatility can invite the chance for more frequent, possibly higher risk/higher reward trading right into your lap; in other words, it can mean traders may not have to chase their trades.

Now, added volatility can sometimes sap volume over time if participants grow weary of uncertainty. Thin conditions can impede transacting exactly when you want to. That means you need to be smart not just with what you trade, but how you trade. A “market order” will always be executed, but in fast markets, you might be surprised when the price where your order is filled differs greatly from where it was quoted. In a volatile market, a “limit order”—placed with a brokerage to buy or sell at a predetermined amount of shares, and at or better than a specified price—may make more sense. Typically, limit orders may cost slightly more than market orders in transaction fees, but can help you control price. Note that a limit order does not guarantee you an execution.

2. Vol Drives This Business. Volatility can sometimes widen the price spreads between instruments, which makes for easier price discovery between buyers and sellers; it essentially means there is more competition, and ideally, both sides get what they want or at least what they can live with. Volatility tends to grow the trading business of exchanges, market makers, hedge funds, brokerage firms, high-frequency trading houses, and others. The financial health of these institutions, some of which are publicly traded, can have an impact throughout financial markets.

3. VIX at 20: Return to Normal? Volatility is all relative, and traders know this. Yes, it was a wild ride for the CBOE Volatility Index (VIX) when it briefly poked a 50 reading during August’s China-led retreat. That’s in contrast to readings below 15 logged for nearly the first two-thirds of the year. And since then, even a falling VIX, known as the market’s “fear gauge,” has so far failed to return to the ultra-low early year readings. But recently VIX has settled in near 20—about what it has averaged over the past decade. You see? Volatility is relative.

4. Can’t Repeat Enough: Inter-Market Moves Matter. What stood out about the late-summer turmoil was that it hit commodity markets, U.S. stock markets, global stock markets, bond markets … you get the idea. Yes, when China sneezes, the world gets a cold. In that case, quiet summer volatility was stirred to life by a series of negative economic readings from the world’s second-largest economy, but even more so by the belief that the whole picture of economic health there wasn’t emerging. Once one domino started to tip, the very real risk of panic grew. But panic didn’t actually grip the markets for any length of time because savvy traders trained to at least monitor global markets could actively hedge and/or speculate once they understood the relationships. Markets were working.

There are also intra-stock-market moves to be mindful of. The interlocking of sectors can exaggerate volatility that may or may not impact a trader’s view of individual stocks or individual markets. Some analysts call it “herding.” The average correlation of the 10 big industry groups in the S&P 500 was about 92% during the August-September downturn, according to Convergex. That’s the highest reading since 2011. The 10-group average correlation for the year up until August was 81%. Sometimes traders recognize volatility for what it is—a chance to catch their breath until cooler times prevail. They know that unidirectional trading amplifies market moves—markets go up or down as a whole, rather than smaller moves among individual names cancelling one another out.

5. Traders Have Options. One of the fastest-growing segments of the retail stock market is the use of listed options. And what makes the options market go round? Volatility. To understand how volatility affects options prices, most traders have a cursory understanding of the Black-Scholes formula, a common model used to calculate options prices. The reality is that most trading systems do the calculations automatically based on certain inputs from market makers. It can be important to distinguish between historical volatility (what the market or stock has done in the past) and implied volatility (IV), or what is implied by the options pricing model. For instance, a rise in implied volatility without a corresponding increase in real (historical) volatility is typically welcome news for the options trader. But there are other, more subtle market shifts that generate potential option strategies. Effects of IV are greatest at the at-the-money (ATM) strike, and less pronounced further away from the ATM strike. If charted, this forms what is known as the “bell-shaped” curve of a “normal” price distribution.

Remember, the effects of IV are greater on options with more time until expiration. That’s because vega, which quantifies the effects of IV on the options, is higher in longer-term options and lower in shorter-term options. The effects of IV can be minimized by combining both long and short options in a single trade, such as in a spread or condor. Check out wide-ranging option strategies in the Ticker Tape Options section.

For many stock and option traders, the potential for success lies with understanding and exploiting volatility, not fearing it.

Opportunity: Everywhere

TD Ameritrade’s mobile apps give you the power to monitor the market, research ideas, and trade everything from stocks to options—anywhere.