(Part 2 of ten-part series on Financial Truths)

 

Section 1: What is Volatility?

Section 2: What is Risk?

Section 3: How to Profit from Volatility and Risk

 

 

Section 1: What is Volatility?

  • Volatility: the variation in asset prices or other financial indices over a given time horizon.
    • Changes in stock prices
    • Movements in interest rates, currency exchange rates
  • Some of this volatility is random and unpredictable, but some can be anticipated by savvy investors who are skilled in technical and/or fundamental analysis
    • I believe that as you expand the timeframe, from minute-by-minute to hourly, daily, weekly, and monthly charts, you get less random noise and more predictable trends and patterns
    • Others believe the shortest timeframes are the most predictable
    • Both perspectives are OK!
  • Actual volatility: can be calculated from historical prices
  • Implied volatility: is the volatility for a future period of time, as estimated by market participants
    • As implied volatility increases, the prices of options (calls and puts) increase along with it
    • The Volatility Index (VIX), calculated by the Chicago Board of Exchange, measures the market’s expectation of the 30-day volatility of S&P 500 Index options.  The VIX is commonly quoted in the media
    • Exchange-traded funds that track the VIX, for short-term speculative trades: VXX, XIV

 

Section 2: What is Risk?

  • Risk is a specific type of volatility: the probability of suffering a loss of a certain size
  • Rooted in probability and statistical concepts
    • A wide range of outcomes can happen over a given time period, from large losses to huge profits
    • The simplest illustration is a bell curve: height represents probability, width represents range of possible outcomes (left=bad, right=good).  Two sample curves below:
    • The market doesn’t follow a bell curve in reality, but it’s a simple illustration
  • Risk is defined differently for every investor and trader
    • 1- You choose the amount that represents a significant loss to you (percentage?  dollar amount?)
    • 2- You choose the timeframe over which to measure profit/loss
    • 3- You choose how often you can accept this amount of loss (there is NO WAY to trade with zero chance of a significant loss)
    • What will you do if/when the loss occurs?  This determines how often you can accept that significant loss (1 in 5 years?  1 in 30 years?)
  • Most trading books recommend limiting the risk of each trading position one-by-one.  Simple, but misleading
    • Common rule: set a stop-loss at 1%, 5%, or 10% of your trading capital
    • Far better to understand the risk level of the entire portfolio of investments and trading positions together.  It’s more complex, but our Trade Analytics and Coaching services will assist you
    • Calibrate the risk level of your portfolio so it matches up with your definition of risk, determined by the 3 components of the prior step.  (1-Amount, 2-timeframe, 3-how often)
  • Your personal risk tolerance determines how aggressively you can invest in the markets, and what kinds of financial instruments you can trade.

 

Section 3: How to Profit from Volatility and Risk

  • Most important: Stay within your own risk management plan
    • Keep enough cash reserves OUT of the markets for things like: job loss, adversity, major purchases or down payments
    • Define a maximum loss over a certain time horizon, and know what you’ll do if it’s reached
  • When implied volatility is too high, sell options (calls and/or puts) to put those fat option premiums in your pocket
  • Keep extra dry powder for crises, panics, downturns, buying “fallen angel” stocks & bonds
    • When the market is stricken by fear, but better times are around the corner, you’ll be able to load up on bargains and wait for normal conditions to return
    • Many institutions aren’t allowed to invest in stocks and bonds below a certain size or credit rating, so they’ll be forced to sell
    • As long as you’re within your overall risk management plan, buy from them at “fire sale” prices
    • Example: VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) vs. oil ETF

 

Intro music by audionautix.com

Find more episodes of the Torpedo Trading Podcast at this link