A deep dive into volatility trading – part 1

Volatility trading is not:

  • Price action trading (between support and resistance)
  • Trend trading
  • Fundamental analysis

Volatility is hidden behind all these techniques but it frightens most people because we talk about noise, probability, leptokurtic distributions, and many more abstruse words.

Volatility is very easy to understand:

P(t) = P(t-1) + e

Where P(T) is today’s price, P(t-1) is yesterday’s price and ‘e’ is the delta between the 2. ‘e’ is the raw volatility!

About price, we usually use median price of the day instead of closing price, to smooth a bit the volatility 😉

‘e’ can also be seen as the 1-day momentum. If ‘e’ is positive than momentum (speed) is up; if negative, momentum is down. This is the beginning of a trading strategy. Don’t throw away your other indicators just yet, because this not usable as such! (At the very least, consider the weekly 1-week momentum and take only signals in the same direction, but the signals can unfortunately be used only in intra-day type of trading)

Interestingly enough, should you program the formula above on a computer using random function with ‘e’ representing anything between 1% and 2% variation up or down, and run 10000 loops at least, and display the results, you will see a graph that is looking very much like the graph above. You will notice support and resistance lines, head and shoulder patterns, triangles, … because you have learned to recognize them but these are mere illusions! Because these patterns can be generated by a very simple program, the conclusion is that they have no predictive power! Or in other words, it just means that if a supposed target is reached, it is purely by chance.

So you are now left with ‘e’ and you can do whatever makes sense to you. You can average, look at standard deviations, look for hidden frequencies with Fourier transforms, …. Remember to keep it simple. When some big pocket start to sell, everyone sells; when price start going up, nothing happens until the hiking is obvious, so there must be some linear component. Which we will see in an other post!

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