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How To Trade Realized Volatility
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How To Trade Realized Volatility

by The MoleApril 6, 2017

I wonder what thoughts were triggered in your head when you saw the featured image above. The notion of a brewing storm is rather ominous and usually is associated with inconvenience, discomfort, and sometimes outright destruction of property. But I chose it very carefully to make a point which I’ll try to convey below. Let’s look at some charts:

2017-04-06_ES_volatility

In case you are new here, the indicator on the bottom of this chart is a slightly altered version of the ATR with a simple Bollinger slapped on top of it. When creating it the intent was to visualize discrete cycles of realized volatility (RV), which I subjectively believe it does fairly well. If nothing else it does show us the wide range that RV can take and how it affects price movements.

The little boxes I drew on the chart highlight periods in which volatility had slowed down considerably, thus producing a very narrow Bollinger bubble. Chartists often refer to this as a ‘pinched Bollinger’ and the associated rule is that an expansion of the underlying is at hand. Since we are measuring realized volatility we are thus looking at moments in time that depict abnormally high contraction of RV (i.e. the ‘pinch’), which in many (but not all) cases results in an expansionary cycle. So far so clear.

What often is forgotten however is that realized volatility (RV), unlike implied volatility (IV), is agnostic to direction, it only cares about velocity (remember: average true range). While IV represents the expectation of future volatility RV shows us the volatility that already has happened in the past. And since the vast majority of traders or investors view rising prices as a positive and falling prices as a negative rising IV is associated with the anticipation of falling prices. Meanwhile RV is a direct derivative of price and as such happily swings in both directions. Which means a drop in price will have (almost) the same impact on RV than falling prices. I said almost because in order to make it the same you would have to normalize the price series but that’s a topic for another day 

When a storm arrives we are often inconvenienced as for example driving in ‘bad weather’ makes things more dangerous for us. But let’s not forget that there’s nothing inherently ‘bad’ about rain and wind in, in particular if it presents itself in relative moderation. Flowers and plants for example wouldn’t pollinate and grow for one and without rain we would be forced to drink saltwater and that’s no fun.

Now there is a reason for my lengthy treatise on volatility and its analogy to weather. Because when I suggest that a storm may be brewing then my inference is not that prices may necessarily fall. It’s easily possible that we are going to see a resolution to the upside, of course most likely not without luring a few bears into placing bets to sweeten the pot a little. Noblesse oblige.

If you take another look at the chart above you will see that the very last box I drew on the very right is also the most rectangular. What does that mean? It means that RV contracted on the E-Mini to a historically low level and remained in that range for an extended amount of time. Not surprisingly that contraction accompanies the juicy rally we enjoyed all the way until my leave to Tenerife. Once again sorry for having spoiled the party.

What Comes Next?

Expansion, which is what we already have been perceiving over the past month. You may also have noticed that the current Bollinger bubble, although being in the process of expanding, continues to be positioned relatively low in comparison with at least the past year of pricing action. Which bodes the question: do the odds support a rise or a further drop and thus a renewed contraction? Just like you I don’t have a crystal ball but at least the limited sample size shown on the chart points toward expansion. And that expansion may actually come in the form of a spike higher followed by a fast drop lower, or the inverse. We. Just. Don’t. Know. But what we do know are our trading and system rules and they should tell us that realized volatility demands a adjustment in stop and campaign management. For me personally that means WIDER stops and SMALLER position size, which incidentally are mutually dependent – see for yourself.

But there is more and we’ve only touched the surface…

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Summary

Properly interpreting realized volatility can lead you to placing better discretionary trades and/or develop more effective systems tailored to exploit specific price behavior. What should have become clear now is that the underlying characteristics of various price series can differ substantially. Nevertheless it is rare to find discussions on this most basic attribute of price propagation in popular trading books or tutorials, the one big exception being the quant sector (for obvious reasons). Short of spending the next 15 years studying to become a quant trader I hope that this post will help you read your charts more effectively going forward.


About The Author
The Mole
Mole created Evil Speculator amidst the chaos of the financial crisis in early August of 2008. His vision for Evil Speculator is a refuge of reason, hands-on trading knowledge, and inspiration for traders of all ages and stripes. You can follow him and his nefarious schemes at various social media waterholes below.
  • http://evilspeculator.com Sir Mole III

    We seem to have an evolving bullish signal divergence. Let’s keep an eye on that:

    https://uploads.disquscdn.com/images/9b73985fb3c9039e74cc31b097c393f816c969d7aae58561420672871b295698.png

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    dust storms are the best. choke and gag, with no water in sight..
    good post. As a trendier trader, I do like direction (dam it). But I’ll take what I can get.
    😉

    http://i.dailymail.co.uk/i/pix/2011/07/06/article-2011713-0CE2030700000578-426_964x626.jpg

  • BobbyLow

    Outstanding! I love what you did with ATR.

    I use Multiples of ATR for my Initial and Trailing Stops. The higher the degree of volatility, the wider my initial stop. When volatility begins to decrease on an open position, my trailing stops begin to get smaller. And as what typically happens when my BB’s get “pinched”, this signals that price is probably going to have a big move. I just don’t know what direction. But because volatility has been reduced as my BB’s were getting “pinched”, my ATR and trailing stop has also been getting proportionally tighter. If price moves against me and hits my stop, I won’t get whacked too badly unless if its an overnight gap. However, if price has a big move in my favor then I won’t get stopped out and as ATR increases so will my trailing stop. I have a different use of ATR than you show in your example but as I was reading your post, all kinds of light bulbs were going off about how Volatility and ATR are joined at the hip. :)

  • Mark Shinnick

    Yes, completely joined; that ever-changing internal dynamic really is an exciting revelation going to the pulse of what’s happening. Have to watch out, however, because longer term atr’s remain important to reference against too much recency bias eventually coming into the model when they are responsive to local behaviors.

  • http://evilspeculator.com Sir Mole III

    FYI – in most trading platforms you can just stack indicators, e.g. throw a Bollinger on the ATR, which should give you something close to what I’m doing.

    Let us know how you incorporate it into your campaigns. Would love to hear more.

  • http://evilspeculator.com Sir Mole III

    The divergence I pointed out this morning seems to be building its way higher:

    https://uploads.disquscdn.com/images/24ba1ebf6344592037d2eac75e360e66059a824c7668a21368daeedcd13c02e8.png

  • Mark Shinnick

    BTW Mole. “EU are behaving like gangsters.” Nigel is a real deal treasure.

  • Ronebadger

    Bear flag, not a “reversal”, so far…IMHO…

  • Mark Shinnick

    Some retest would be in order, long tza.

  • Mark Shinnick

    Flat.

  • http://evilspeculator.com Sir Mole III

    Yeah, that one cracked me up to no end :-)

  • Ronebadger

    The poor VIX…it doesn’t know if it’s on foot or horseback

    http://stockcharts.com/public/1092905/chartbook/428507379;

  • Mark Shinnick

    Rebot tza.

  • http://evilspeculator.com Sir Mole III
  • http://evilspeculator.com Sir Mole III

    I actually remember posting about this in quite some detail. Did you catch my last two momo updates?

  • Mark Shinnick

    Well, from a blow off POV, a new local low could be a great bear kill.

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb
  • Yoda

    and then WW III started…

  • ridingwaves

    or CL gets a nice bid and follow thru with the drumbeat

  • Yoda

    so does gold, but I don’t feel like celebrating.
    neocons never left the WH, and the Trumpster conned a lot of people, including myself, into believing that things will be runned differently with him in command.
    “Drain the Swamp” was just a catchy phrase. Joke’s on me.
    I hope cool tempers prevail in the end.

  • http://gerb-reloaded.blogspot.com/ Gold_Gerb

    overnight while you slackers were sleeping, Syria get’s smacked.

    one hour isn’t a trend, but it’s a start!
    go go Gold.

    https://uploads.disquscdn.com/images/aa079f3b591ad922a0e0c0f3008190097db975955057e346d4c26b9b59b603f3.png
    -GG

    Evil never rests, and the Sun never sets on EvilSpec™

  • Scott Phillips

    Yeah the nerve of that guy!

    Who could have believed that the guy who lied about everything his whole life would lie to his own supporters!

    The nerve of that guy!

  • http://evilspeculator.com Sir Mole III

    Oh shit….

  • StockTalker

    Spooked