VOLATILITY SYSTEMS

Volatility and time are some of the most commonly used measurements in trading. However, volatility, like time, is not always well understood. Volatility will also be studied in the money management and options, but for now, we will concern ourselves in applying it to trading systems. There are many ways to calculate volatility, but in this section we will use the percentage price change of the market. Therefore, if the market moves from 100 to 110, the volatility or percentage change is 10% [(110 - 100)/100 = 0.10].

Volatility trading systems are based on the following premise. If the market moves a certain percentage from a previous price level, it has broken out of a trading range and is a buy or sale. This type of system is called a volatility breakout system. There are many variations on this, but the general idea is to catch a move which breaks out above or below a band or envelope of prices.

How are the bands or breakout ranges determined? One way of calculating the bands is to use the moving averages of the highs and lows of the market, as discussed previously. Another type of band which may be created is a volatility band around the price data. A buy or sell signal occurs when the market moves beyond a certain percentage amount or volatility from the previous level.

Let's look at a way to use a simple system. Assume the market price is 100, and a volatility or percentage level is 5%. The lower range of the price band becomes 95 (100 . 0.95 = 95), and the upper range of the price band becomes 105 (100 . 1.05 = 105). A buy signal is generated if the market moves above 105, and a sell signal occurs, if the market moves below 95. The market must hit one of these bands within a certain time frame or the trade is canceled.

How are the percentage levels chosen? The market volatility is a good start because it tells what percentage moves have occurred in the past. Any increase above the normal volatility level of a market may signal a strong change in trend.

The concept of a volatility breakout system may have partly originated from options trading. Many options traders have positions which need to be hedged if the market goes above or below certain levels. A typical position might be a straddle where a call and put are sold. Some of the bigger traders automatically buy above and sell below the market at predetermined levels to decrease part of the risk of their positions. The effect of this buying or selling at specific price levels may cause the market to go even higher or lower' if there are many orders bunched at the same price levels.