Risk and Reward: The Hidden Advantages of Volatile Market Conditions
Volatility in the market is the rate and size of price changes in either direction over a given period of time. The term “volatile” is used to describe a market where large and frequent price fluctuations are common.
How well you can anticipate and capitalise on price fluctuations in volatile markets will determine whether you lose money or make money. Volatility opens the door to both risk and opportunity.
Thankfully, it is not a zero-sum game. It’s not a case of all or nothing. You’ll be relieved to find that volatility can be managed. Even better, taken advantage of it. There is great wealth hidden inside volatility. We simply need to find it.
Understanding the relationship between risk and reward during volatility
Risk and reward are inextricably linked, if not inseparable. In other words, you can choose one to leverage the other.
Minimise your risk for a lower reward or maximise your risk for a higher reward. The truth is that accurate measurement is impossible. Risk is defined as the “probability of loss” if we distil it.
There are indicators and algorithms, but even when done properly, there is always some unpredictability owing to unforeseen circumstances. One of the most prevalent methods for determining risk is standard deviation, which is a statistical measure of dispersion around a central tendency.
The outcome of any risk-reward decision can only be accurately judged by glancing in the rear-view mirror as the previously predicted probability crystallises into a tangible certainty. You’re either laughing or weeping at this moment.
Making quick, precise, and unbiased decisions in unpredictable markets like cryptocurrency and Forex is both financially and emotionally difficult. But what if this was done methodically such that we could give consistent results?
The Risk-Reward trade-off is always a personal metric. Everyone maintains their equilibrium. All that remains is to discover this equilibrium and manage it properly.
Many considerations must be made for each decision, including the market situation, the magnitude of the risk, the size of the return, our risk tolerance, the investment duration, the possibility to replace losses, and others.
It is not an easy task to evaluate. After removing the noise, estimating risk reward comes down to weighing probabilities. Probabilities are capricious (because if the probability is not correct, it is incorrect), and being incorrect entails losses – not what you want, especially when your hard-earned money is at stake.
As a result, we are continually faced with a dilemma: if we overestimate risk, danger may strike. You might lose everything. However, if you over-minimize, the size of your award will be reduced.
Your goal is to obtain the best remuneration for the risk you are willing to take. You adapt your risk gladly, embracing and accepting the possibility of reduced rewards.
Different types of market volatility
Volatility is one of the aspects that financial market participants consider when making trading decisions. There are two main approaches to volatility, each with advantages and disadvantages:
Realised volatility, often known as historical volatility, is a statistical measure of how the returns on a specific asset or market index are distributed over a specified timeframe.
Typically, historical volatility is calculated using a financial instrument’s average deviation from its average price over a certain time period. The standard deviation is the most commonly used measure of realised volatility, while there are several approaches for calculating this metric.
A risky security is one with a high historical volatility value, yet this is not always a negative aspect in certain types of transactions because both bullish and bearish conditions can be risky.
In this context, historical volatility (backward-looking) acts as a baseline measure, whereas implied volatility (forward-looking) defines the relative values of asset prices.
The term implied volatility refers to an asset’s projected volatility and is a common component in options trading.
Implied volatility represents how the market expects volatility to be in the future, but it does not predict how the asset’s price will move. In general, an asset’s implied volatility rises during a bear market because most investors expect its price to fall more over time.
It falls in a bull market because traders expect the price will climb over time. This is due to the widely held view that bear markets are intrinsically riskier than bull markets.
Implied volatility is one of the measurements used by traders to forecast future price changes of an asset based on a variety of predictive factors.
Navigating market fluctuation
Buy and hold strategy
Volatility can benefit all types of investors. Typically, more conservative traders choose the buy-and-hold approach, in which a stock is purchased and then held for a protracted period of time, frequently several years, to reap the benefits of the company’s incremental growth.
This technique is predicated on the notion that, while the market may fluctuate, it generally delivers long-term profits.
While a highly volatile stock may be a more stressful option for this technique, a modest amount of volatility might actually mean higher returns. As the price fluctuates, it allows investors to acquire stock in a solid company at a low price and then wait for cumulative growth down the line.
Volatility is considerably more important for short-term trading. Day traders deal with changes that happen second by second, minute by minute. There is no profit if the price does not move.
Swing traders use a little longer time frame, usually days or weeks, but market volatility remains a key component of their strategy. Short-term traders can utilise chart patterns and other technical indicators to assist timing the highs and lows as price swings back and forth.
Swing traders can identify potential reversal points as price oscillates by using indicators such as Bollinger Bands, a relative strength index, volume, and established support and resistance levels.
This means that they can go long on the stock, or buy calls, when the price approaches a low, then ride the rebound to sell at or around the high.
Predicting when a volatile stock’s present bullish momentum is exhausted can mean shorting the stock or buying puts just as the downturn begins. Individually, these types of short-term transactions may provide smaller gains, but a highly volatile stock might afford nearly endless opportunities to play the swing.
Numerous smaller payoffs over a short period of time may wind up being more profitable than one major cash-out after years of waiting.
The Cboe Volatility Index, or VIX, is a market index that is updated in real time and indicates the market’s estimate of 30-day forward-looking volatility. It gives a gauge of market risk and investor sentiment based on the price inputs of S&P 500 Index options.
It is also known as the “Fear Gauge” or “Fear Index.” Before making investment decisions, investors, research analysts, and portfolio managers use VIX levels to gauge market risk, worry, and stress.
Volatility-based securities that monitor the VIX index were developed in the 2010s and have proven extremely popular among traders for both hedging and directional plays.
As a result, the buying and selling of these instruments has had a substantial impact on the original index’s functioning, which has been turned from a lagging to a leading indicator.
VIX futures provide the most direct exposure to the indicator’s ups and downs, but equity derivatives have gained popularity among retail traders in recent years.
Options are a very important asset to any portfolio during times of high volatility. Put options provide the holder the right to sell the underlying asset at a fixed price.
If an investor purchases a put option to bet on a decline in the underlying asset’s price, the investor is pessimistic and wishes for prices to fall.
The protective put, on the other hand, is used to hedge an existing stock or portfolio. When building a protective put, the investor wishes for prices to rise but is purchasing puts as insurance in case stocks fall instead. If the market declines, the puts grow in value and offset portfolio losses.
While puts increase in value in a falling market, all options increase in value when volatility rises. A long straddle combines a call and a put option at the same strike price on the same underlying. The long straddle option strategy is a wager that the underlying asset’s price will go significantly higher or lower.
The profit profile is the same regardless of which direction the asset moves. Typically, the trader believes that the underlying asset will go from a low volatility state to a high volatility one as a result of the impending revelation of fresh information. Aside from straddles and puts, there are various additional options-based strategies that might profit from volatility rises.
Any market can be profitable if you know how to approach it. Traders with experience in volatile markets may tell you that there are a variety of approaches that can assist produce profitable results.
One is to enter the market cautiously and slowly, and another is to pick your trades carefully. Since market volatility can lead to “whipsaws,” investors should maintain a healthy dose of humility and be ready to pivot quickly if things start to go south.
Don’t let your emotions get in the way of your trading; instead, stay concentrated, keep tabs on your transactions, and accept little gains as they come.