Now That You Know Volatility, Here's How to Play It

Shah Gilani

Volatility comes in all shapes and sizes. It affects every stock, every market, and every asset class, everywhere around the world.

It can be your best friend or your worst enemy.

Either way, as Sun Tzu said, "Keep your friends close and your enemies closer."

But whether or not volatility is your enemy today, tomorrow, or next week, you have to know how to manage volatility in your trading.

Here's why you have to embrace volatility, how to see it coming, and how to trade it.

Volatility Comes in a Lot of Flavors

Volatility is every stock, every bond, every commodity, and every tradable instrument's constant companion, so make it your best friend.

Like I mentioned earlier this week, there are a couple of types of volatility and they all mean different things.

Inherent volatility is how much and how quickly the value of any investment or market increases or decreases.

There are two types of inherent volatility: the first is historical volatility, which is measured by calculating the historical standard deviation of annualized returns over a given period of time.

The other is implied volatility, which is the expected volatility that buyers and sellers price into an asset at the last or average price at which it trades.

Volatility can also be relative.

How volatile one stock is relative to another stock, where stocks can be substitutes for each other, matters. How volatile a stock is relative to the volatility of the market, measured as beta, matters. Changing volatilities of different asset classes in a portfolio, especially in risk-parity funds, matters.

Both inherent volatility and relative volatility matter.

Some investors shun volatility, while others, especially traders, seek volatility.

Volatility itself doesn't discriminate. It just does what it does, until it completely changes, and then it usually reverts to its mean.

That's the nature of volatility. That's why it's important to know the inherent volatility of investments you own and know how market volatility can affect your investments.

Knowing the inherent volatility of anything you own can be complicated or easy.

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The complicated way to know how potentially volatile an asset is requires you to do the math.

The easy way is to look at how it trades over calm market periods and stressed periods. You can really see its highs and lows and the swings it makes when comparing the two periods. You can measure the swings relative to the average price over each period, and you'll have a good general sense of how volatile that asset has been.

What's important about knowing and being comfortable with how inherently volatile your investments are is they are going to be impacted by larger market forces.

Understanding how they're reacting and how what's going on with market volatility can impact the inherent volatility and value of your holdings will help you make smarter buy, hold, or sell decisions.

I've been trading professionally for 35 years. And for me, the volatility of markets (and by markets I mean equity markets, bond markets, commodity markets, currency markets, derivatives markets, etc., especially when they are highly correlated) is more important than the inherent volatility of any single investment.

That's because market volatility, because of its impact on sentiment, on psychology, on fear and greed, will, especially in stressed times, move most assets as if they're tied together like climbers on a steep-faced mountain.

The mother of all market volatility measures these days is the VIX.

It's the "vol" measure to watch because so many important equities, so many portfolios, so many asset managers, so many asset classes, are in, tied to, compared to, or correlated in some way to the S&P 500, which is what the VIX is a volatility measure of.

I recently told you what's really causing the wild market swings, and when we last spoke I talked to you about volatility basics. Some of these concepts are heavy, but these articles will make sure you're not diving into the water without your floating device.

Tapping into the "Fear Gauge"

If you understand the VIX and can trade it, not only will you be able to make money from it, you'll better understand how everything in your portfolio trades. And the more you know about how things trade, the easier it becomes to make money trading them.

Here's how easy it is to follow and trade the VIX.

Shah Gilani

About the Author

Browse Shah's articles | View Shah's research services

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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