Measuring the coast: Volatility and Option-Like strategy

Discussion in 'Forex - Currencies Forums' started by Daniela-TFC, Oct 15, 2014.

  1. Daniela-TFC

    Daniela-TFC Active Member

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    For those familiar with the real chaotic (fractal) nature of financial markets, volatility is an intricate concept. As Mandelbrot states, one can not give a definitive measure for a coast line, as the result value depends on the scale or the tool employed for the measurement: should we divide the coast in one km. or in 1 m. pieces, the final result will vary, being bigger in the second case. The same is true for volatility if we understood it as ‘the movement of the price’. Likewise, the more we zoom in the market charts, the more a price goes in one direction and bounces back showing up movements that are normally hidden for higher time scales.

    In this, my first article I would like to introduce what, as far as I know, is a new method to measure the volatility, based on the simulation of a strategy for which starting from a price level at time=0, every movement of the market will be replied with the virtual opening of a trade order in the direction that opposes movement.

    Let’s make one example: consider EURUSD price be currently 1.3200. It will be our starting point. From now on, on every 50 pips step in any direction we will open a virtual order: if the price goes up to 1.3250, we will sell a Lot; if the price goes down to 1.3150, we will buy a Lot. The more steps in the same direction, the more orders we open in the opposite direction of market movement. Eventually the price change direction, and then we start closing those opened orders as soon as they have a 50 pips profit.

    We don’t keep this going indefinitely. On the contrary, there is an established number of steps after which all remaining open orders, if there’s any, will be closed. Next a new cycle will begin.

    The result of this simple strategy resembles that of a combination of purchasing one CALL and one PUT options, main difference being we don’t depend on time of expiration nor pay primes for the traded options. But the essential behaviour is there: you can initially bet the volatility, understood as movement of the price, will be higher or lower than a value. That value in the case of trading with options is related with the inherent risk felt by the market participants (implied volatility). In our humble strategy it is the average movement of price, as in a random walk.

    So according to our forecast of the extent of future movements of market, i.e. our expected future volatility, we can choose either to buy/sell options to form a long or short straddle, or on the other hand we can decide to follow the strategy described above, accompanying the market movements or opposing them, with the hope that the final position of the price will fall closer/further away relative to the initial point than the average displacement in a random walk system.

    If everything is clear so far, let’s complicate it a bit: why should I choose a starting point and no other, with say 5-10 pips shift? Why a step between ‘trading decisions’ of just 50 pips? What number of steps to use before closing a cycle? Well, we needn’t use just those values in the examples above. In fact we need ALL the values of initial position and step to get a more robust averaged result. But it is not so bad as it seems, as depending on the time scale we want to work with, movements of the price will not be higher that a certain value (eg. 300 pip steps would be too much for 1H EURUSD charts), and as for the initial point, it should be enough if we pick all the starting points not spanning a range bigger than twice the step size. Finally, the number of steps after which we declare the cycle is finished will also be enclosed by the volatility itself. For instance, we cannot set it to 100 steps with 100 pips/step if it’s going to take months to the price to walk all this length.
     
    Last edited: Oct 15, 2014
  2. dianethare

    dianethare Senior Investor

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    I think i 'll need a pen and paper for this, for future reference and to re-read over and over till i get it right...ah! better yet, i'll just bookmark this particular page...thank you Daniela for that vital piece of information. :)
     

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