An intuitive way to think about price volatility is investor confidence in the specific instrument, that is, how willing the investors are to invest money into the specific instrument and how long they are willing to hold on to a position in that instrument. As price volatility goes up, because prices make bigger swings at faster paces, investor confidence drops. Conversely, as price volatility goes down, investors are more willing to have bigger positions and hold those positions for longer periods of time. Volatility in a few asset classes often spills over into other asset classes, thus slowly spreading volatility over to all economic fields, housing costs, consumer costs, and so on. Obviously, sophisticated strategies need to dynamically adjust to changing volatility in trading instruments by following a similar pattern of being more cautious with respect to the positions they take, how long positions are held, and what the profit/loss expectations are.

In Chapter 2, Deciphering the Markets with Technical Analysis, we saw a lot of trading signals; in Chapter 3, Predicting the Markets with Basic Machine Learning, we applied machine learning algorithms to those trading signals; and in Chapter 4, Classical Trading Strategies Driven by Human Intuition, we explored basic trading strategies. Most of those approaches did not directly consider volatility changes in the underlying trading instrument, or adjust or account for them. In this section, we will discuss the impact of volatility changes in trading instruments and how to deal with that to improve profitability and reduce risk exposure.