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example, if the price was $100 and it increases to $105, it was a 5 percent change, just as a stock that was at $20 has a 5 percent gain when the price goes to $21. Typically as a market becomes more volatile it becomes more risky, and vice versa. The volatility of a market can change over time. A market can quite easily go from low volatility to high volatility overnight. This is often because of unexpected or important news. Likewise, a market that is highly volatile can suddenly become very quiet again, often because of news. Typically the latter transition (from high to low volatility) takes longer, since markets require more time to calm down than they take to get excited. |
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An excellent example is the grain market. The grain market can exhibit periods of high volatility primarily because of weather patterns that could affect or are affecting crops. As the volatility of a market increases the risk, the profit potential increases as well. It is important to remember that the unavoidable and uncontrollable risk (which we will discuss shortly) will always increaseit is guaranteed. Likewise, the profit potential is also guaranteed to increase; however, profits are not guaranteed. Many novice traders forget that even though their potential profit increases as the market becomes more volatile, the unavoidable and uncontrollable risks are also constantly increasing. A major problem with a market that is experiencing high volatility is the slippage factor. In addition, the bid/ask spread widens to infinity in a fast-moving market, resulting in horrible fills. Generally a trending market has higher volatility; however, the reverse is not necessarily true. The market can be very volatile with no trend evident. Entering a market that is exhibiting high levels of volatility can be a nerve-wracking experience for many traders. |
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Consequently many traders think that a market with low volatility is better to trade in. However, low volatility may indicate that there isn't enough price movement for profit. The reward-to-risk ratio may suggest that it is a poor opportunity to trade. Low-volatility markets typically have a lot of random price movements (i.e., the locals in the pit are moving the market) or congested price patterns. In addition, markets with low volatility often have increased costs of trading. Problems with bid/ask spreads, commissions, and lack of price movement tend to reduce the already small profit potential offered by a low-volatility market. As a trader, you must do the research to compare present volatility with historical volatility. The novice trader is best served trading a market that is exhibiting a relative moderate level of volatility. |
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