Volatility is the measure of how prices change against a period of time. When volatility is high, this implies rapidly changing price levels while low volatility implies less change. In order to profit in the markets, some volatility is required, however the way it is perceived depends on the risk tolerance of the investor.
Rapidly fluctuating prices present increased opportunities to profit on trades, making volatility advantageous for some investors. Investment instruments like CFDs (Contracts for Difference) are used to speculate on price changes of an asset and are favoured by many traders during volatile market conditions.
Volatility trading, therefore, becomes a popular strategy for CFD traders. This post will show you how to master volatility trading with CFD.
- What is CFD Trading? >
- Use of CFDs in Volatile Markets >
- What Causes Market Volatility? >
- Four Measures of Volatility >
- Why Volatility Is Important for Traders >
- Finding Opportunities to Trade Volatility >
- Risks In Trading Volatility With CFD >
- Strategies & Tips for Trading in Volatile Markets >
- A Final Word >
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A CFD is a contract between an investor and a broker that pays out the difference between the initial and settlement price of an asset at a specific date.
They are similar to other derivative instruments like futures and options, with a few key differences:
CFDs are available for a wide range of investment instruments (including cryptocurrencies) and can be easily created;
● CFDs are bought and sold over-the-counter;
● There are minimal barriers to CFD trading and entry positions can be as small as a single share ;
● Unlike other derivatives, CFDs do not have an expiry date;
● CFDs are normally issued on a 1:1 basis with their underlying investment instrument.
Volatile markets present opportunities for investors to speculate on price movements using derivative instruments like CFDs because they can make profits on upward and downward changes. The more the prices move, the greater the opportunity. A “long” position is taken if the trader believes the price will go up, while a “short” position is taken if the prediction goes the other way.
✔️ Volatility and Short-Term CFD Trading
CFDs are popular with short-term day traders because the profit potential depends on high volatility over short time frames, and many traders rely on quick movements to make profits.
When time spans are considered, volatile markets are particularly favoured by short-term traders, because without the volatility there are fewer opportunities. These types of traders rely heavily on technical indicators in an attempt to time the market and place positions with the aim to catch the profitable side of the trade.
✔️ How Long-Term Traders Can Use CFDs
Traders with portfolios containing positions in long-term investment assets sometimes use CFDs as a protection mechanism to reduce the risk (also known as “hedging”) of downward price movements in the market.
For example, If an investor believes that the price of an asset will go down, they can use CFDs to take a short position and profit on the decrease in price, offsetting any losses from the value decrease of the stock in their portfolio.
Predicting market movement in volatile conditions requires an understanding of the nature of volatility and its causes. This gives investors an edge in timing the market and can be used towards creating a strategy that leverages the opportunities that volatility provides.
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Major events like rate change announcements, political turmoil, natural disasters or health panics (like the recent COVID-19 event) caused investors to take drastic actions that affected the financial markets.
Volatility is measured in several ways, and can be as simple as price changes or complex as mathematically-derived indicators.
● Historical Volatility
As explained above, price changes over time represent the most basic form of volatility - referred to as historical volatility. It is the standard deviation of the change in the price of a market asset or investment instrument when compared to its historical price over a period of time.
● Implied Volatility
Implied volatility is a metric used by options traders to make estimates on the future fluctuations of an investment instrument based on a set of predictive factors. It is a complex mathematically-derived metric commonly used by options traders.
● Volatility Indices
Volatility indexes are also specific to options prices. They are key measures of the market expectation of volatility implicit in the price of options. Like implied volatility, they are mathematically-derived metrics used by advanced traders.
● Intraday Volatility
Intraday volatility represents the specific market movements that take place during the course of a trading day. Unlike historical volatility that demonstrates fluctuations over longer periods of time, intraday volatility is the measure of the daily price upswings and downswings of an investment between the open and close of a daily trading session.
As discussed above, the volatility of a market asset is important for investors depending on their risk profile.
Investors with a long-term “buy and hold” strategy generally prefer more predictable or steady rates of change - unless the general direction of an instrument’s price is constantly moving up.
Short-term day traders or speculators that use derivatives profiting mainly on moves up and down thrive on volatile market conditions. They represent opportunities for them to take positions and try to profit on the right side of the trade.
Is Volatility Good for Traders?
As explained above some types of traders favor volatility and view it as an opportunity to increase their profits by using derivatives that allow them to take bets on the movement of asset prices whether they go up or down.
Since volatility simply means a change in price, a constant upward trend is obviously favoured by all investors, however this rarely takes place over the short term. High volatility and the rapid price changes it provides is mostly advantageous to short-term traders.
CFDs are a popular way to trade in volatile market conditions. One of the keys to a successful strategy for some traders is to find opportunities for sharp market fluctuations and use them in their favour.
Volatility Trading Indicators
Prior to purchasing CFDs, an investor can source out opportunities by looking at market indicators, specifically technical tools that can help them identify potential upcoming volatility in almost any type of market.
Tools such as Bollinger Bands, Kelter Channels, Stochastics, Average True Ranges (ATR) and other indicators allow short-term traders to get a current view on the movement of the markets and adjust their trading activities accordingly.
Use Research to Find Volatile Stocks
Since CFDs for stocks are very popular, some traders conduct research to discover what stocks are experiencing high-value fluctuations.
Various websites like Stock Fetcher use filters that help users track the most volatile stocks. Depending on the filters, one can set a % amount for the application to track, and place positions accordingly.
Another option is to do research on the top gainers, losers and the most volatile stocks using resources on the web. Mainstream sites like Bloomberg are very popular along with other applications like FinViz and NASDAQ.
Trading Volatile Currency Pairs
Trading currency pairs involves speculating on the price change movements between them. The more stable the currency, the lesser the volatility and major currency pairs like EUR/USD, USD/JPY, GBP/USD and USD/CHF generally have less volatility due to the more stable economies they represent.
When traded against currencies from emerging markets like USD/ZAR, USD/KRW, and USD/BRL there is increased volatility. The general rule is that the liquid (widely used) currency pairs have less volatility while those in emerging market economies have higher volatility.
Trading Cryptocurrencies in Volatile Markets
Cryptocurrencies are investment instruments that do not correlate very much with market movements and are purely speculative. This makes them highly volatile and unpredictable.
Whether an investor is a day trader, swing trader or a buy-and-hold investor, they must understand an asset class very well in order to trade successfully. Having said that, cryptocurrencies are usually a very difficult asset to trade due to the volatility of the markets.
Trading cryptocurrencies requires a full understanding of how and why their prices move and who the main buyers and sellers are, including their motivations.
Using CFDs to speculate on cryptocurrencies requires knowledge of all these factors in order to estimate price movements. Because of the highly speculative nature of trading cryptocurrency CFDs, the investor must have an edge over the average market participant either through analysis or insider information. This is why trading in cryptocurrency CFDs can be very risky and best suited for advanced traders.
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Since CFDs are considered to be high-risk investments, they are mainly suited for advanced traders and those with a very high tolerance for risk.
The use of leverage (funds borrowed from the broker) is preferred by many traders because it allows them to place larger positions. While this gives potential for greater profits, it can also magnify the losses, resulting in a complete and total loss of capital.
Investment advisors commonly recommend to make minimum use of margins and to calculate the positive and the negative potentials of any trade prior to placement. In addition to these measures, full market research is advantageous for all traders regardless of their trading strategy.
Volatile markets are never predictable, however the price swings offer many opportunities for investors. The following list of tips are useful for both beginner and advanced traders that offer basic suggestions that can benefit all investors:
1. Observe the markets and make a plan
When it comes to day-to-day trading, the markets are never the same, so it is wise to watch the activity in order to understand what is occurring prior to taking action.
This allows investors to take time to observe what the market is doing, find any potential patterns in volatility, and to make a structured plan.
2. Start with a small position
In times of great volatility, the potential for loss is higher than normal, so starting with a reduced position can reduce overall risk.
Since the use of margin amplifies risks, it is also wise to avoid or minimize its use during unpredictable market conditions.
3. Use stop-loss orders
Stop-loss orders are instructions to stop trades at a certain price point. They are commonly available on most trading interfaces, allowing investors to exit trades once prices hit a certain level.
Many traders use these orders as insurance policies to prevent the loss of capital and minimize risk during volatile market conditions.
4. Avoid short time frames
Short-term traders use smaller time frames and multiple trades in an attempt to profit. When the markets are highly volatile, however, it is wise to extend the time frame if the markets are highly unpredictable. This allows the trader to take time to assess what is happening and refine the strategy if necessary.
The use of longer time frames can help traders make better observations about the movements of the market in addition to helping them formulate a more effective strategy.
5. Make a plan and stick to it
Trading based on excitement or emotion is the enemy of most investors because it often results in bad decisions that risk the loss of capital.
Most advisors suggest that traders create a plan based on a strategy that is well-researched with clear loss limits. This will help investors avoid bad decisions based on emotions, allowing them to maintain their capital and avoid losses.
Depending on the investor, market volatility can be an advantage or a risk. Investors interested in value-based investing for the long term tend to dislike highly volatile conditions while short-term investors thrive on the opportunities that volatility provides because it lets them take advantage of price upswings and downtrends.
Among the many tools available to investors, CFDs are popular investment instruments that help investors leverage volatile market conditions. Despite their risk (especially when leverage is used), they are a preferred option if the investor has done their research, is confident about their strategy, has a plan, and understands how to read market indicators.
When combined, all these factors can be used towards a winning strategy that can flip the risk of market volatility into profitability.
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