GUIDE | TRADING BASICS | BEGINNER
Trading in Volatile Markets
Sharply moving prices can provide great opportunities once the risks are mastered.
Trading is risky.
What is volatility?
Volatility is the statistical tendency of a market to rise or fall sharply within a certain period of time. It is measured by standard deviations – meaning how much a price deviates from what is expected, which is generally its mean. Experienced traders know that volatility can come at any point, in any part of the interconnected markets we trade. Smooth trending markets or rangebound markets can also be interrupted by sharp shocks and unwanted volatility.
If we are able to control emotions such as greed and fear, we need to also then have the ability to capitalise on explosive price action. There are several ways to determine when and if markets are volatile, and numerous strategies we can use to either preserve our capital or hopefully profit from falling and rising volatility. The best traders, those in it for the long-term, will always have rules and strategies to use when price action starts to become unpredictable.
What do volatile market periods look like?
When volatility increases, we should see wide ranges in price, high volumes and more trading in one direction – for instance, few buy orders when the market is tanking, few sell orders when the market is ramping. At the same time, traders can be less willing to hold positions as they realise prices can change dramatically — turning winners into losers.
Deeper analysis of market volatility suggests that there is a higher probability of a falling market when volatility is high, with lower volatility being more common in rising markets.
The emotional rollercoaster of trading and investing: a ride every trader must endeavor to smooth out
At market peaks, traders feel content about their returns and believe the favourable market environment will stay in place for an indefinite period. Trading is seemingly the best job in the world, as it is easy to manage risk and pick winners. In other words, complacency has set in and any red flags are dismissed.
The flip side is the emotional stages of a downtrend in the market. A state of denial can quickly turn into anxiety. This loss of confidence sees plans and strategies changed or even forgotten as fear sets in, before the dreaded sense of despair turns into capitulation.
This last period is where traders reach their breaking point. The pain is only relieved by pressing the sell button and there is often an inability to think rationally. This stage is the classic ‘be fearful when others are greedy, and greedy when others are fearful’ point, a well-known phrase uttered by legendary investor Warren Buffet. The strong hands are accumulating at this point, while the weak hands are still in liquidation mode.
Fear and greed are the two key ingredients that feed volatility. They are the real foundations of price action when volatility increases and can occur on any time frame. Scalpers through to day traders and swing traders all experience this.
How can I measure volatility?
As we know, volatility measures the overall price fluctuations over a certain time. There are numerous ways traders can measure these movements. One of the most well-known is the Volatility or VIX index.
What does ‘volatility’ mean?
We’ll break it down for you.
Introducing the VIX
The VIX measures the market’s expectation of 30-day forward-looking volatility in the S&P 500 index. Calculated by prices in options, a higher VIX reading signals higher stock market volatility, while low readings mark periods of lower volatility. In simple terms — when the VIX rises, the S&P 500 will fall which means it should be a good time to buy stocks.
A reading below 12 is said to be low, whereas a level above 20 is deemed to be elevated. For the record, the all-time intraday high is 89.5 which occurred in 2008. Comparing the actual VIX levels to those that might be expected can be helpful in identifying whether the VIX is “high” or “low”. It can also provide clearer indications of what the market is predicting about future realised volatility.
There are other similar indices in bond and currency markets implied by option pricing, which are also very useful in measuring volatility.
Fear and Greed Index
The VIX is included in another widely followed barometer known as the Fear & Greed Index. Here, CNN examines seven different factors to score investor sentiment, by taking an equal-weighted average of each of them. The index is measured on a scale of zero to 100 – extreme fear to extreme greed – with a reading of 50 deemed as neutral. The index has become a bellwether for when fear is at its peak.
History shows that this indicator can be a reliable guide to turning points in the stock markets. For example, the collapse of Lehman Brothers during the GFC in September 2008 saw the index sink to a low of 12. 3 years later, the gauge had hit 90 as global stock markets rallied hard after the final round of the Fed’s asset purchase programme – QE4
If we want to dig deeper into more specific price fluctuations regarding a particular market, it is worth looking at implied and realised volatility. The former represents the current market pricing based on its expectation for movement over a certain period of time.
This forward-looking figure allows a trader to calculate how volatile the market will be going forward; for instance, the implied move and range for a currency pair with a significant degree of confidence. This is extremely useful for calculating stop distances and position size.
Realised VolatilityThis is the actual movement in prices that takes place over a defined historical period. Technical analysis indicators like the Average True Range (ATR) and Bollinger Bands can help us to define this. The ATR shows how much an asset moves on average during a given time frame. A falling ATR signals narrow price ranges, therefore volatility is decreasing. A rising ATR points to growing volatility.
Bollinger Bands depict rising and falling volatility. They act like dynamic support and resistance levels and can signal overbought or oversold conditions. The bands widen when volatility increases, and narrow when volatility falls.
5 practical tips for trading in volatile markets
Trading is a risky business – essentially, you are managing your risk constantly throughout the day on each position you hold, or calculating the potential risk on new positions. Let’s look at five principles a trader should employ when volatility increases:
Order types - always use a stop loss, as you will know the exact amount of risk you are willing to take on the trade before you enter it. Remember, “it’s not the money you make that makes you a winning trader; it’s the money that you don’t lose.” If you are using moving averages to set levels, consider using long-term averages to reduce the chances of a price spike triggering your order when volatility is high.
You could also consider using limit orders which potentially reduce your risk by buying slightly above the market price. In effect, you are making the market rise a little more, which means you are buying into the trend rather than against it.
Take profit limit orders are important as well – successful traders know the upside potential on their trades and what price they will exit when they are in the green. This eliminates emotional trading, which is more important than limiting your upside – you can always re-enter your trade if you get new signals.
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Trading is especially risky during volatile times
Using CFDs in volatile times
A CFD is a financial derivative based on the underlying market which enables you to open positions with a high degree of leverage. You buy or sell contracts which represent an amount per point in that market.
When volatility increases, you can use CFDs to diversify some of your positions. In currencies, this might involve betting for the US dollar in one position and against it in another. In stocks, you could spread your risk across sectors, market cap or geographic region.
In this situation, you might not only use full positions with these trades, but take on even larger exposure. Such a strategy may offset profits, as well as risk. It may also add complexities to your trading that may not be welcome.
That said, diversification done well should result in capital preservation in heightened times of volatility.
As you do not take ownership of the underlying asset, trading CFDs means you can deal on both rising and falling markets. They give you the opportunity to go long or short on a broad range of instruments including stocks, indices, forex and commodities.
Trading CFDs can be especially effective when buying and holding shares in overseas markets. In effect, you have currency exposure so using FX CFDs can reduce the impact of currency fluctuations on your physical portfolio.
In the same way, volatile stock markets can potentially be hedged using CFDs on indices. On the other hand, if you are expecting a sharp downturn, then you could take a short-term position in a safe-haven asset which, in theory, should retain its value if the market takes a turn for the worse.
Gold is a classic example of a safe-haven asset. There are a variety of strategies to use, including trading assets that move in a different direction to your existing positions or positions that directly offset your existing one. Whichever way you choose, CFDs are a great way to neutralise market exposure when volatility is high, as you need to be able to take positions in both directions.