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Profiting From Volatility

Investors who understand even small changes in price can mean huge profits or losses are likely to make money…

When the legendary J.P. Morgan was once asked to predict what was going to happen in the stock market, he responded, "It will fluctuate". That simple statement is about the only prediction that can be made with certainty regarding short-term price movements in a freely-traded financial market.
Prices may move up or down. But they will fluctuate. There will always be a random element to every price change. That randomness cannot be avoided or suppressed. But volatility can be taken into account and strategies can be built while allowing for it.
When you add high leverage ratios to such a scenario, even small changes in price can mean huge profits or losses. Traders and investors who understand this, and accept the existence of random volatility and cater to it, are more likely to make money.

Two key ratios
When any trade or sequence of trades is initiated, two ratios are crucial. The trader should try and make a "best guess" at the win:loss ratio - the number of times the position is likely to be winning versus the number of times it is likely to lose. The trader would also like to know the return:risk ratio. This is the return on each winning trade versus the loss on every losing trade.
The combination of the two determines overall profitability. To take a simple example, a trade with a 1:1 win loss ratio (one win in every two trades or 0.5 probability) and a 2:1 return:risk (2 units return/win for every 1 unit paid out/loss) ratio will offer an overall profitability of 5 units for every 10 trades.
In certain markets, traders often take positions with extremely skewed high risk:return ratios. A venture capitalist, for example, will back 10 businesses knowing that say, seven will fail and two will be moderately successful. But one, he hopes, will be a multi-bagger, offering better than 10:1 returns. Similarly an option trader may take far from money positions that will not be struck under most circumstances. However, when such a position is hit, it will offer multiple returns that compensate for many losses.
When an unhedged position is taken, it usually has a directional bias and roughly 50 per cent chance of making money. Most traders and investors focus on trying to improve that win:loss ratio. There are many variables associated with price change. For example, a trend of higher earnings growth is usually associated with higher stock prices, and conversely, a scam is likely to be associated with falling prices.

Be prepared for losses
By isolating and examining such variables, it is possible to improve the win:loss ratio somewhat. But there will always be a random element associated with price changes and in practice, even the best analysts find it difficult to generate better than 60-65 per cent win rates. This means that even a great trader must be prepared to lose money at least once in three trades and it is prudent to assume that money will be lost more often than that. This is equally true for a long-term investor - even the greats lose money every so often and rarely have win:loss ratios better than two out of three.

Set a loss limit
Another strategy is to focus on the return:risk ratio. Rationally, this makes more sense. After all, it is entirely in traders' control to cut off a losing trade. Thus at least one factor - the possible risk in a losing trade - can be controlled. If the trader sets that loss limit per trade as non-negotiable, all he has to do is seek trades which promise higher returns as and when they do win.
Setting a loss limit and sticking to it with discipline ensures that several other things fall into place. Position size, for example, is almost automatically determined. Certain contracts will be eliminated because they are too volatile or because they require too much cash down. Other contracts will be eliminated from consideration because they are too stable - they aren't volatile enough to generate desired returns.
For example, let's say that a trader is interested in stock futures and he's prepared to lose `10,000. Stock futures are available at leverages of roughly 10:1 and market lots start at a minimum `2 lakh in value. That means the trader has to put around `20,000 down in margin. Then, he's prepared to lose 50 per cent of his margin and 5 per cent of the position value.
So, he can try to identify contracts which swing say, 2-3 per cent per session. This way he will need three or four sessions in his favour to create a favourable return:risk ratio. Equally importantly, he can afford to wait out two or three adverse swings before his loss limit is hit. So, the position has some amount of time in its favour to generate returns. However, if the trader picks a `8 lakh lot with a `10,000 loss limit, the risk of getting knocked out is considerably higher. He will hit his loss limit if there's a bad 15 minutes in a single session, since his limit equates to a 1.2 per cent swing.

Trading in the forex market
Obviously critical details like margin and leverage are important. In the forex futures market, for instance, margins are around 50:1. So a small fluctuation can generate huge gains or losses. A focus on the return:risk ratio becomes even more important in such circumstances of extremely high leverage.
Currency futures and currency options are very seductive contracts. They have very high leverage; they are exceedingly liquid; there is ample fluctuation. They are also near-perfect examples of contracts where win:loss ratios cannot be improved easily. The central banks of the world, individually and collectively, possess more information than any trader. Yet central banks are frequently wrong-footed by moves in the very currencies they issue. While Japan, Europe, and the US remain in economic turmoil, there will be huge fluctuations in global currencies. That reflects directly on the rupee and rupee-denominated futures as well as options are easily available. Cross-currency positions can also be taken using the rupee as a common factor. For example, a stronger USD versus the Euro can be exploited by taking a long USDINR, and a short EurINR position, in effect buying the USD and shorting the Euro. Using such high-leverage instruments in a situation of high volatility can be a double-edged sword. Exporters and importers will perforce be playing this game. Some of them will probably register massive treasury gains and others will register big losses.
A prudent currency trader should not expect to generate a win:loss ratio that is much better than 1:1. He should instead try to manage his risks and set realistic loss limits to generate a high return:risk ratio. This may be entirely possible if you can create a stop-loss based system that lets winners run while cutting off losses at an acceptable limit.