Irrefutable Law of Trading Success #5: Volatility is Your Friend

Let's talk about volatility being your friend. If we take trading and we make it really, really simple, there's one thing that we need to be able to make money. Do you know what that one thing is? Think about for a minute, what's the one thing you need to be able to make money? You need range. You need the market to move. Of course I'm not talking about if you have like a short option strategy or anything like that, but I'm just talking about in general, right? If you trade directionally, the way you make money is by the market moving and the more it moves, the more money you make. Think about that for a moment. Because what is volatility, volatility is about movement, it is about range. If we want to make money, we need to trade things that move the most. When we talk about volatility being your friend, we're going to talk about it in two different categories today. The first is the level of volatility. We can go through and this is one of the things that we do we take all the products in our universe, and we rank them by volatility, from the most volatile, the highest volatility, all the way down to the lowest volatility and that is one of the factors that we use to be able to determine what it is we're actually going to trade. In general, you will make more money trading things that are higher volatility, than you will trading things that are lower volatility, just think about it, when you trade high volatility, you get feedback, the market moves, it does not sit there. If you get long, it tends to rally, maybe it really breaks but you get movement, you know whether you're right or wrong. When volatility is really low, you can buy something, and it just sits there and sits there and sits there and moves a little bit in your favor, and then it comes back. If the market doesn't move, you can't make money. One of the best ways to scan for the top markets to trade is to rank all the markets by volatility and make sure you focus on the most volatile markets. We go into stock indexes, and we look at stock indexes, what is the most volatile index? NASDAQ, people love to trade NASDAQ because it moves, okay. Think about that. Do you look at the products you trade? Do you think about the volatility level? Because that's a big help. 

Now, the second component is essentially the volatility trend. Now, I always hesitate to say volatility trend, because in many respects, volatility doesn't quite trend. But maybe a better way of saying it is volatility cycles, volatility will cycle from low volatility in contraction, to high volatility in expansion and when the market gets too stretched, I often like to use this rubber band, this red band in my classes. Because when the markets contracted, there's like slack in the line. bark is quiet and basically when it's too contracted, it needs to move and so we're in a trading range, what happens is the market starts to move. As it starts to move, volatility starts to become more and more stretched. We've moved from contraction, and eventually we move into extreme volatility and when volatility is extreme, one of the most reliable statistical edges is when volatility is too extreme, it will not last, it creates an unstable state that it's not sustainable to stay there. We often say is when the market gets too volatile, one of two things is going to happen. It's either going to snap back and revert, or it's going to break and what break means is that occasionally, you'll see a futures contract, or an ETF literally break in which it gets so volatile, that the contract falls apart and never reopens again. Okay, so this does happen. It does happen and in the years to come, it's going to happen a lot more. But 99.9% of the time, when a market becomes too extreme, it snaps back and that's an incredibly reliable pattern that you can trade. We have the volatility cycle, we see markets go from low volatility to high volatility and high volatility to low volatility. If we understand the cycle and we understand where we are in the cycle, volatility becomes our friend. Volatility is really contracted, we could be looking for strategies and movement for it to expand. If volatility is too extreme, we can look for signs it's going to revert. We can play the reversion directionally or we can play certain volatility strategies to benefit from volatility reversion. 

Volatility is your friend. Now, if you're a long term trend follower, goes back to the volatility cycle. If you get in when volatility is low, it is your friend and he can be a great trade. If you get in late when volatility is extreme, and you go with the trend, it can cause enormous pain. It can be very difficult to manage positions in an incredibly volatile environment, especially if you don't know what you're doing. Okay, but that is more the exception. The rule is trade markets with a high volatility level, trade markets into volatility cycle, be aware of where they are in the cycle, and trade the cycle. In these cases, that makes volatility your friend and this is an edge that a lot of traders don't look at. They don't look at it for market selection. They don't look at it for identifying the market environment, identifying the optimal strategy. It's Tuesday and every Tuesday I come to you with tips like these today to help you take your performance to an elite level, it's Trader Tip Tuesday. I hope you have an awesome week and I will see you next Tuesday.