Volatility-based trading approaches have traditionally been popular among hedge funds, commodity trading advisors, and other professional traders. There are many ways to gauge volatility (see “Related reading”) and incorporate it in a trading strategy. Of the different ways to characterize and trade volatility, the best are based on the tendency of volatility to “revert to the mean.”
The premise behind volatility mean reversion is that periods of extraordinarily high volatility should be followed by periods of lower, more normalized volatility. Similarly, periods of extraordinary low volatility should be followed by periods of higher, more normalized volatility. This tendency is reflected by the familiar progression of a market that meanders in a narrow trading range (a low-volatility condition), only to explode out of the consolidation and embark on a strong price trend (a highvolatility condition). Eventually, the price move exhausts itself, at which point volatility will again fall to a lower level.
We’ll analyze the two simple methods for trading volatility in the forex market: inside days and short term/ long-term volatility comparisons.
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