Trading can be broken down into two broad categories: short term and long term. Long-term traders focus on the change in price of an asset over weeks, months or even years. Short-term traders look at price movement over a period of minutes, hours or days. This latter type relies on intraday volatility to generate profit from the market.
The price of a financial asset -- a company’s stock, for example -- will fluctuate over time. This fluctuation is the stock’s volatility. The up-and-down price fluctuations between the open and close of a trading session is that stock’s intraday volatility.
Breakout Volatility Trading
There are a number of ways you can use volatility in your trading. The first is through a volatility breakout system. For an intraday volatility breakout system, you need to first measure the range of the previous day’s trading. The range is simply the difference between the highest and lowest prices of the stock you are analyzing. Next, decide on a percentage of this range at which you will enter. Many traders use 70 percent, with a higher percentage being a more reliable entry and a lower percentage being a less reliable entry. Next, calculate the levels at which you will buy the stock if it rises or sell the stock if it falls. Finally, once the price breaks through one of these levels, enter in the direction of price movement. For example, if the price of share XYZ moved between $2.50 and $3.50 yesterday, its range would be $1, or 100 cents. 70 percent of 100 cents is 70 cents, so your buy level would be 70 cents above today’s opening price, and your sell level would be 70 cents below.
News-Based Volatility Trading
Many traders monitor important press releases and use them to take advantage of the volatility they cause. Depending on the asset class you are trading, different releases will create different levels of volatility. For example, if you are trading an individual stock, you might look for the release of the company’s annual or quarterly financial, or earnings, reports. Alternatively, if you are trading a currency pair, you might look for the host nation’s gross domestic product statistic. GDP measures an economy’s production rate over time. If the press release is positive -- for example, say a company reports better-than-expected earnings -- then you might consider buying the stock on the assumption that its share price will rise during the day on this good news.
While volatility can help traders generate profits from financial markets, it can also cause large losses. If you buy a stock in a volatile market, its value can fall just as quickly as it can rise. For this reason, you should always incorporate strict risk management principles and thresholds into your intraday trading. Risk management principles can include using a "stop loss," which will automatically exit a trade if it goes against you by a predetermined amount, and only risking a certain percentage of your trading capital on any one trade.
Samuel Rae is an experienced finance journalist whose work has been published across a range of different sites and publications in the financial space including but not limited to Seeking Alpha, Benzinga, iNewp, Trefis and Small Cap Network. He holds a BSc degree in economics.