Do Not Let Low Volatility Affect Your Trading

Low volatility is boring. It means no-one can get it badly wrong, which in turn means no-one can make big money. Yet reduced volatility is also an opportunity. It is a boring opportunity, but investing and trading should be boring. Avoiding the pitfalls of low volatility can leave you in a better position to profit when others are not patient. 

What is low volatility?

Low volatility means price changes are small and less frequent. In financial trading and investing terms, this means the change in stock and index values. There is no one recognised way of measuring volatility, but the two below are among the most widely recognised and quoted by the financial media.

Beta is a measure of volatility which compares the volatility of a stock versus a market, usually an major index. (Examples include FTSE100 and the S&P500 among others.). If your stock has a Beta of over 1, then your stock is more volatile than the market.

Typically the most volatile stocks are the ones which the least stable earnings. This is usually negative but can include companies which are growing quickly and as a result are growing their revenues substantially.

The Sharpe ratio measures the return you get for the risk you took. Risk in financial terms is measured using volatility, If you make 20% return having taken an extremely large risk, then you were successful this time.

In the longer-term, the opportunity will not concrete itself, but the risk will and you will lose all your investment. It is therefore often better, to take less risk and make a lower return.

The Sharpe ratio may not be the most obvious volatility measure but it is an incredibly useful one for new investors. It teaches you a great deal about focusing on risk-adjusted returns and having a margin of safety.

When does it occur?

There is no one clear scenario when reduced volatility occurs. The following re examples which can lead to it.

• Pause for breath. If a stock has advanced strongly often as a result of positive news, it may trade in a smaller less volatile range for a period
• Calendar periods. August and December are notably quieter periods in markets as traders are on the beach or up a mountain skiing.
• Complacence. If there is no news, in particular bad news, then volatility decreases. This often leads to markets drifting upwards, increasing risk!

How can you spot low volatility?

One obvious clue, is seeing an index trading in a narrow range. An example of this can be seen in the S&P500 over the previous 12 months. Although the peak-to-troughs are in the region of 20%, the index is essentially trading in a range, It is unable to break out to the upside but also keeps bouncing on a resistance level.

The VIX is often seen as a proxy for what traders think and is given according importance by market participants. It is informally known as the 'fear index'. It measures the number of newly opened option contracts. The more contracts are open, the greater the expected volatility.

Lower trading volumes are indicative of less trading activity. This is often caused by investors being unsure what next and preferring to 'wait and see'. Lower volatility and lower trading volumes at the same time is indicative of greater future volatility.

Low cash allocations are an indication of investors being confident in growth and not seeing any change in prices. Usually they are wrong. When volatility does reappear, the downside risk makes many traders sell in panic, causing increased volatility.

Watch out of the low volatility boomerang

Typically periods of reduced volatility are followed by periods of increased price action. Do not get caught out by this - respect and trust your risk model! Discipline is your friend. It may save you have from your emotions, which are your worst enemy.

This is because when it disappears, traders get complacent and start taking increased risk. This is in turn leads to losses, but more importantly less capital to invest when opportunities do appear.

Remember volatility may disappear for a while but it always comes back in some form, usually with a vengeance.

Conclusion

Quieter times are an occasion for you to prepare for future opportunities. Do not feel the need to trade. Enjoy this period to refresh your mind. Why not look for risks you had previously thought existed?

This could lead to you avoiding losses. In turn you can to be aggressive when a discount appears. Often this is because others have taken too much risk and are force to sell at the wrong time. This will allow you to be greedy when others have become fearful!