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Volatility and its psychological effect

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Some useful tips how to use volatility to get profit

Volatility often causes panic on the market but trades don’t know that they increase the volatility in many cases. We analyzed the phenomena of the volatility, how in influences the market and how get profit from volatility.

What is volatility?

To trade binary options with volatile assets is difficult, not because of the high risk, but primarily because of psychological factors. It is known that volatility is stability of the price for changes asa result of external factors. In the financial markets, volatility doesn’t occur occasionally; it’s created by the traders through the principle of "I do what others do." Traders, because of panic, create volatility of the asset.

Volatility and psychological effect

As soon as large investors begin to sell binary options, traders do the same because of fear and uncertainty. The fear arises because of expectations to take losses. As a result, with the release of the external factor, which has minimal effect on the market, traders increase this effect. This situation is like an avalanche, which should reach the bottom and break.

Volatility in stock markets

If you look at the chart of volatility, you will see that it is always a sine wave. After a prolonged growth, a meltdown always occurs. That is, when the asset is in the overbought zone, there is an understanding that the price has reached the "ceiling" and, therefore, will not grow further.

So, you need to hurry to sell the binary option to minimize your losses. In addition, growth in the value of assets is always associated with something positive, and so the expectation isthat the asset is profitable. During the fall,the reverse situation occurs: Under the influence of psychology, the trader believes the decline is a negative phenomenon and tries to invest as little as possible.

However, traders who are constantly working with financial instruments don’t fear volatility. They understand that volatility provides additional chances for profit.

Trading volatility

Volatility is a chance to make large profits. Without panic, you can learn how to buy and sell volatility. With the strategy of volatility, a trader uses straddle or strangle. Such cases can be positive for the trader:

1. The market expects a decline or growth; the direction does not matter.
2. In general, the market may be calm, but sometimes strong price jumps should happen.
3. The price of the asset of the option doesn’t change, but the potential implied volatility increases.

If the likelihood of price change is minimal, or its variation will be insignificant, the trader can sell volatility (to sell a straddle or strangle). However, in this case, the trader needs a calm market. In the case of a quiet market, the trader’s profits are generated through time decay and the reduction of internal volatility of the option.

Trading stocks

If we talk about stock binary options, it’s best to consider the purchase of stock options with low volatility. Until recently, Apple and Alibaba stocks were considered stocks with low volatility.

Often inexperienced traders tend to buy stock options when they are growing. In the case of decline, they wait for the new increase in the cost, in order to sell and make a profit. This is explained by the same psychological factor; it is difficult to buy the stocks when they become cheaper.

When does volatility increase?

The value of stocks primarily changeswhenreports are publishing by the companies. Statistics shows that the volatility of the stock increases by 6% to10%onthe day of the report.

The list of leaders regarding the increase in volatility include the stocks of BroadSoft (BSFT), Fuel Systems (FSYS), and Netflix (NFLX). Apple's stocks are not included in this list. Analysts analyzed 52 days of the publication of the company’s quarterly reports. On the day of publication, the Apple's stocks change in the value +/-5.44%, which is even lower than the average volatility of US companies’ stocks (+/-5.52%) on the day of reports publications.

Why Non-Volatile Apple stocks became volatile

On August 24, 2015, "Black Monday" for the US stock market, Apple stocks showed record volatility. On Monday, the stock opened at $94.87, which is $10.89 lower that closing price of the previous day. During the day, the stocks fell to a low $92.00, but then rose to a maximum $108.80 and ended the day at $103.12.

What upset investors?

This decline wasn’t caused by the publication of the company report.It was caused by the publication of weak data from China, where the main production of Apple is concentrated and 36% of all iPhones are sold. Weak data on the Chinese economy raised concerns about the future of Apple's sales in the country. At the result, investors started to panic, which resulted in a record-breaking volatility for the stock.

Another giant, Chinese company, Alibaba, showed record volatility. This company showed a very successful IPO, when it was able to attract $22 billion. The initial stock price was $68 per share, which reached a high of $119.15.

What upset investors?

Problems with stocks began after the publication of data on revenue, which amounted to $4.22 billion against a forecasted $4.45 billion. The company's net profit decreased by 28%. These data became the catalyst for the volatility. Then, volatility increased by further statements about a 45% growth of active customers.

After the data on the Chinese economy, the company's stocks broke through the level of the original value, $68, and reached a low $58.55. Later, the stocks managed to recover, but the price still remained lower than the original, $66.75.

During stressful situations, the correlation between companies’ stocks in the same sector increases. They move almost simultaneously. This is confirmed by stocks of Apple and Alibaba.

Comments

vinayak1000's picture

I really enjoyed reading this post. It was a very enlightening piece on how to deal with volatility. Overall good tips. I've bookmarked this article for future trading reference.

vinayak1000
baller's picture

Hello. I think the main point you are trying to make is that Volatility can be viewed as mean reverting, that is defined as after it spikes due to some external reason, it usually calms down back to it's normal value range.

This can be seen in viewing the VIX, and it's derivative products.

The danger is you can open a position in selling volatility before the peak is in. The other danger is being too short before the expiration window.

Basically, if a temporary situation occurs that causes panic, do the opposite of the crowd and profit. :)

baller

Disclaimer: The article is written for informative purposes only and it is not financial advice. The author does not have any position in the currency pairs mentioned, and no plans to initiate a position. He wrote the article himself and expressed his own opinions. He has no business nor personal relationships with any mentioned government entities or stocks. Readers should not treat any opinion expressed by the author as a specific inducement to make a particular trade or follow a particular strategy, but only as an expression of his opinion.

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