Novice and experienced traders alike vie for an edge that can be used to pull profits out of what many consider random or efficient markets. Usually, this involves a complicated mix of indicators and set of rules for entry, stops, objectives and at least a basic structure for risk management among other components. However, one factor that is often over-looked by both technical and fundamental traders is the part that volatility plays in an overall successful strategy and even each trade. A lack or abundance of volatility could mean the difference between a 10-minute trade and a 10-week trade or what direction the market takes; and thereby it may even determine whether a strategy is successful or not. In this article, we will define volatility, note its typical drivers, offer ways of measuring it, and then show how to apply it to trading.

Volatility is traditionally defined as the variance of returns for a market or index over a certain period. In more informal language, volatility can be referred to as the level of fluctuation in price over time. For example, from the beginning of 2000 to the middle of 2008, the average daily change for the popular US light sweet crude futures contract was 1.74 percent. In comparison, the 10-year Treasury note (T-note) futures contract averaged only 0.3 percent. Therefore, going forward, we would expect crude oil to be a more active security on a day-to-day basis than the T-note. What’s more, volatility for each instrument can and does change over time. On the average day from 2000 to 2008, the Dow experiences a 0.75 percent daily change. However, on a day populated with a number of highly anticipated earnings releases or when the Federal Open Market Committee is expected to deliver a rate decision, activity can be far greater.

The comparisons above highlight two different ways to look at volatility from a trader’s standpoint. In the first, a security’s relative volatility can be used to determine what type of strategies should be used when trading that particular asset. Since the T-note does not see large daily fluctuations in price action, there is a lower probability of suffering large losses or substantial gains over the short-term. As such, a buy-and-hold or positioning strategy would be better suited for that asset. In contrast, crude experiences sharp swings on a daily basis; so day trading or scalping would offer a better platform risk management and profit taking. The second approach to volatility is to monitor the change in price action for one asset over time. A general decrease in volatility - say for the Dow Jones Industrial Average - over time may lead a more active trading program to reduced returns and less frequent positions. Another common issue is a sharp jump in volatility that is short-lived and could be expected to revert to a mean.

Regardless of the market, the sources for volatility are generally the same. The most common spring for price action are general market conditions such as overall market size, liquidity, trading limits and demand among other factors. For those markets that are deeply liquid and demand is relatively stable (such as it is for Treasuries), price action will be less volatile. On the other hand, if the balance of supply and demand is frequently skewed, changes in price action can be very dramatic.

The other typical driver for price action is scheduled and unscheduled event risk. Whether its an earnings report for equities, a major refinery shutdown for crude or a change in interest rates for fixed income, each of these events can generate substantial volatility. However, the difference between these dynamics and general market conditions is that the events are temporary; and any price action that results from them diminishes relatively quickly.

There are many different ways market participants and analysts use volatility and as a result there are just as many ways to measure it. The three most popular gauges however are price action, implied volatility from derivatives and market-specific indicators.

-Price Action - While some go to great lengths to quantify volatility and reveal its hidden nuances, the easiest – and most discretionary – means of interpreting it is through simple price action. Before volatility itself became a trading strategy, traders were watching the day-to-day or minute-by-minute change in stocks, futures and other assets to asses the relative strength of price action and using these observations to predict future market conditions. Time and generations of experience have provided axioms like: a period of consolidating price action often leads to a breakout; gaps precede significant momentum; and activity will usually reverts to a mean.

-Implied Volatility - Derivatives like the futures, forwards and options were invented as a hedging tool to allow a party with an economic interest in the underlying instrument to limit unwanted risk and set a future transaction price. For savvy speculators though, the real value in these prices is the component that measures the market’s expectations of volatility over the life of the derivative – known as implied volatility. Without this important pricing factor, derivative insurance would be consistently over or under priced. In turn, with this component, the consensus for expected price action is laid bare to those wanting to take measure of the market’s bias.

-Market Specific Indicators - While price action and implied volatility are sound measures of volatility, their scope is sometimes limited and they often require interpretation. To answer this problem, indicators were created to make it more straightforward. One of the most popular indicators for gauging expected volatility (and many believe fear) is the S&P Volatility Index (VIX). Though it is an aggregate of implied volatility in equity options, the indicator is a standard for the entire financial market. Other indicators follow similar lines. The DailyFX Volatility Index measures implied volatility in the currency market, the Momentum Indicator follows trends in price action and Bollinger Bands take account of the activity around a stabilized moving average.

Now that we know what volatility is, its causes and how to measure it, the next step is to incorporate this knowledge into trading. There are many different types of trading styles, but many of them can be classified into two different types: the kind that benefits from high volatility and those strategies that excel in low volatility. Event trading, technical breakouts and collecting unreasonably high premiums all depend on unstable price action or expectations of such. Alternatively, calm price action is necessary for those successful range traders, steady trends and collecting yield differentials.

-Event Risk - Also known as trading the news, event risk trading is one of the most common methods of trading across the market. In a world of retail traders and hedgefunds, most market participants expect to realize their profits in days or hours – not weeks or months. To reasonably expect a decent return over such a short period, a strategy must implement dangerously high leverage or rely on those period’s of unusually high price action. But, how does one predict these times with any kind of accuracy? The most dependable means for generating volatility is an important indicator release or announcement. An earnings report or economic indicator is an event that the market can prepare for, whose release time is reasonably known by everyone and can catch traders off guard.

-Breakouts - Trading on event risk depends upon outside influences to produce volatility. Technical purists however, prefer to use find their signals for impending volatility from price action. One of the most common scenarios for chartists to trade is the breakout. When price action has been restrained by an obvious trendline or is uncharacteristically low, there is a considerable chance that a breakout may follow. Using indicators like implied volatility or the S&P VIX can signal a big move is about to occur and a trader can position to take advantage of the ensuing momentum.

-Selling Insurance - Options traders are well aware of the concept of selling implied volatility; however this concept applies to all markets. When a derivative is pricing in a high probability of extreme price action, there is in turn a greater cost in securing a contract that promises a sure price. Such a cost is really reflected in the prevailing price for all markets. When there is heavy speculation that a market may move dramatically higher or lower in the near-future, these expectations begin to actually impact the market. Should such prevalent fears fail to materialize, an asset will return to is ‘fair value’ as traders unwind the premium initially placed on expected volatility.

-Range Trading - History repeats itself. This is the motto most technical analysts live by. One of the most popular ways of exploiting this adage is through range trading. When price is rebuffed repeatedly by general levels of resistance to further rallies and declines (support), there is greater probability that traders won’t try to stretch their luck and trade beyond such points - in furthering the strength of the resultant range. Trading these market conditions requires consistency - the foil of volatility. If price action explodes, there is a far greater chance it will break through any technical barriers.

-Riding The Trend - Though it seems a polar opposite to range conditions, trend trading actually relies on low volatility as well. When a market is moving in one direction, the best set of circumstances if for a consistent move along that course as explosive price action can result in a sharp move against the dominate trend and encourage a trader to abandon a trade or simply be stopped out. A stable advance or decline allows for stringent money management (trailing stops, building into a position, etc.) and thereby mark a better trade.

-Carry And Yield - While there are those traders looking to collect premium on unusually high market volatility, there are also market participants that look for stability to collect a consistent income. There are many types of strategies that take advantage or real or perceived return in a position that involves one or more assets. Perhaps the most popular styles of this type of strategy is the carry trade in the currency market. In this plan a currency with a high benchmark interest rate is bought and one with a low interest rate is sold so that the difference between the two yields is collected in the daily rollover. This steady income is usually small, so any capital losses seen in a reversal in the exchange rate can easily wipe out the positive carry effect.

Volatility is one of the most frequently described and used market conditions in trading. However, to use it appropriately, a market participant needs to know how it defined, measured, produced and applied to truly take advantage of the abstract concept’s benefits.