Market prices seem to move randomly. One parameter that does have some predictive power is volatility. A good measure of volatility is implied volatility. Implied volatility can be a good parameter of the assessment of risk in the marketplace. The problem is that volatility tends to reflect an interpretation of past movement and less of an assessment of risk at its current level. Volatility contracts and expands with price movement. Option players will bid option prices up as price moves to compensate for their rise in risk. This is reflected in a rise in implied volatility.

Using Volatility

Volatility can be a valuable tool in the trader’s arsenal. First, it can be a risk parameter for stops. As volatility expands the noise of price movement increases. The calculation of stops should have a volatility component. As volatility increases the stops should expand thus reducing your contract size. For instance, if volatility spikes in the crude oil consider moving your stop out from 50 cents to a higher level to reflect the added risk. This will lessen the impact of noise volatility on your results. Conversely, a lower implied volatility market allows for a contraction in stop levels. This can be a powerful tool. Since volatility cycles between expansion and contraction, you will be increasing your chances of catching a multiple risk move from the cycle transfer with a higher contract size. When implied volatility is low , go for breakout trades and but option premium.