In financial markets, volatility is the statistical measure of how extremely and how quickly the prices are moving. Let’s try to understand it with a simple example :

Illustration 1 : Price Path

Let’s say that the stock has to move from Price A to Price B. One thing is very certain that it cannot travel from A to B in such a smooth line. The actual movement in any securities would look something like the one shown in the image below :

Illustration 2 : Explaining Volatility

As we can see in the image above, From Price A to Price C, the prices were deviating much less from the trajectory or the mean that it had to follow however, the deviation in price from the trajectory is much and expanding from price C to B. It can be said that Price A to C represents period of low volatility and Price C to B represents a period of High and expanding volatility. All instruments generally go through cycles of expanding and contracting volatility.

Factors affecting Volatility :

The price of any instrument is a function supply and demand. There are several variables which influence supply and demand of any instrument. Factors like interest rates, news flows, investor sentiment, natural disasters are all playing a role in determining the supply and demand. At any given point of time, these factors will be influencing the price at varying magnitudes and direction. This causes huge fluctuations in price.

Maturity and liquidity of the markets also plays a major role in determining the volatility of the markets. More mature markets have less degree of volatility while immature or emerging markets generally experience large degree of volatility.

What does volatility mean for investors and traders :

To understand this, let’s go back to the image of volatility that we saw earlier.

Illustration 3 : Explaining dynamics of volatility

For traders, the period of Price A to C is not as favourable as the period C to B as to make same amount of money or to capture same magnitude of price move, the trader will have to spend more time in the market in the A-C region however same magnitude of price move can be captured in a very short time in the region C-B.

It is also much easier to outperform the market by huge margin in the C-B region by capturing each price swings. There are also certain disadvantages for the traders in the volatile markets as the changes of Stop-loss being hit or changes of exhausting the margin required to maintain a position are high because the price can very quickly move against the trade. This makes it important to be highly disciplined and have a robust system to trade.

Investors hold their positions for a much longer duration than the traders. Volatility is not favourable for investors as it makes predicting the returns at any given point of time much difficult.

Demonstrating Some Real World Examples :

Let’s check out a very simple strategy on a popular volatility indicator, Bollinger bands. We will be using Streak The conditions of the strategy will be very simple :

Entry : When 15 min candle crosses above upper bollinger band

Exit : Based on 1:2 Risk:Reward using 1% stop-loss and 2% Target