How Traders Can Take Advantage of Volatile Markets
If markets never moved, nobody would make any money. Short-term price movements are normal. All markets, from forex to the FTSE 100 rise and fall on a minute by minute basis. Some degree of volatility is to be expected but many traders prefer to sit it out when trading conditions are especially volatile. If your appetite for risk is low, this is a sensible strategy, but there are ways to maximize your returns in volatile markets.
What is a Volatile Market?
Volatility is a statistical measure of standard deviation.
The Investopedia definition of standard deviation is:
Standard deviation is a measure of the dispersion of a set of data from its mean. It is calculated as the square root of variance by determining the variation between each data point relative to the mean. If the data points are further from the mean, there is higher deviation within the data set.
When the standard deviations are applied to a long-term rate of return in a market, it provides a measure of the volatility of the said market. For example, volatile stocks have a large standard deviation whereby they deviate significantly from their average price, whereas stable stocks have a lower price range.
Forex is a good example of a volatile market. Forex, like other financial markets, is influenced by numerous macroeconomic factors, but liquidity is the main factor. In forex, liquidity relates to supply and demand, so major pairs such as GBP/USD are less volatile than exotics such as GBP/JPY because these currencies are more widely used.
Tip #1: Make sure to select the appropriate instrument or currency pair depending on your desired volatility tolerance: if you’re looking for a fast-paced instrument that has multiple changes in direction and offers many entry and exit points, looks towards pairs including the British Pound or commodities like Gold. If you prefer a more slow-paced, trending instrument look towards the Swiss Franc or CFDs on the global stock indices.
The Difference between Volatility and Risk
Volatility and risk will both impact your investments returns, so it is important to understand the difference. As we have already explained, volatility refers to the ups and downs seen daily in the world’s financial markets. We have no control over events that cause upswings and crashes – unless we happen to be Mark Carney, Governor of the Bank of England, or Jerome Powell, Chair of the Federal Reserve – so we have to be on the ball and recognize when an event might cause a reaction in the markets.
A risk is a different story. Your appetite for risk determines the decisions you make. But, and this is very important, there is a distinct relationship between volatility and risk. We may decide that a volatile market is our opportunity to make a huge profit. There are big opportunities to be had, so we silence our doubts and buy when it’s on an upward trajectory. Unfortunately, when prices take a sharp tumble, we panic and sell, often at a far lower price, which leads to huge losses. Psychologists call this behavioral risk.
It’s no different in forex trading. There is an element of the herd mentality. Even experienced traders sometimes “follow the crowd” rather than use their best judgment. If you adopt this strategy, you are in danger of missing the optimum moment for making a trade.
Define Your Objectives
What’s your risk profile? It is important to define your objectives before you start trading. By their very nature, volatile markets are high-risk, which means if you are not careful, you could lose your shirt, and then your pants.
Before trading in any markets, define your risk profile. If you can afford to take some losses, your risk profile will be higher. Most traders, especially inexperienced ones, prefer to minimize their risk during volatile trading conditions, but ultimately, it’s your decision. Your most prudent strategy is to minimize risk when trading in volatile markets, but if you are willing to take some risks, it is possible to profit from the markets when trading conditions are volatile. However, be aware that the potential for capital loss is high.
In theory, younger investors are less susceptible to market volatility. They very often have long-term investment plans, so short-term volatility is a minor blip. They know that the market will rise again soon, so they don’t panic. Older investors, particularly those close to retirement age, are more likely to panic and make rash decisions during periods of volatility.
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Different Trading Strategies
The main objective of trading is to make money. Traders make money when they correctly guess whether a price will move up or down. There are more opportunities to make money in a volatile market, as price movements are more extreme. Whether you are a beginner or a seasoned investor, you can profit from market volatility, but you need the right strategies.
Tip #2: Keep in mind that different trading strategies work better in different trading conditions even on the same instrument. The fact that you’ve done well on a specific instrument by employing a “follow the trend” strategy for a few weeks or months doesn’t mean that you will do equally well if this instrument changes the character and gets into a consolidation phase. You should adjust and change to a strategy that allows you to pick highs and lows or “reversal points” as long as the sideways price action persists.
Don’t Panic Sell
It’s only natural to look at falling prices and assume now would be a great time to exit your position, but this is not necessarily the right strategy. Try and keep things in perspective. Yes, the market is in freefall, but it will pick up again if you hold your nerve. Selling now could cost you dearly and may not be the right strategy.
Panic selling after the Brexit vote in 2016 wiped $2 trillion of the world’s financial markets. Wall Street suffered its biggest fall in 10 months and the European markets took a severe hammering. Sterling plunged from $1.50 to $1.33 against the dollar. FX traders had a terrible day.
Exchange rates move fast during periods of volatility. It is, therefore, reasonable to expect volatility to continue for a period after the main event. Following the May 6 flash crash in 2010, 14 out of the next 23 days saw a range of 100 pips or greater. Experienced traders widened their stops and took lower risks on open trades.
Tip #3: Always have an exit plan in place before entering a trade. And stick to it! This means that before clicking on “Buy” or “Sell” to get into a trade you should always have decided where you plan to exit your position, in profit or loss. This allows you to make a calm decision on your acceptable profit/loss parameters and you should always stick to this decision and avoid moving these exit levels at any time. When you’re in a trade greed or fear will cloud your judgment and a habit of moving your exit levels will rarely end up in your favor.
Forex traders can reduce risk by widening their stops and reducing their trade sizes. Your trades may be smaller, but the market is moving faster, so there will be greater opportunities for to trade.
The markets have since recovered, of course, so while such short-lived events are disastrous at the time, they are mercifully rare. The point is that if short-term crises cause you to have palpitations, consider whether a long-term, more conservative portfolio is more in tune with your tolerance to risk. Conversely, if you are after aggressive growth, trading in a volatile market is the answer.
Fortune Favours the Brave
Don’t stay clear of forex trading when the market is choppy. Often, turbulent times are actually the best time to invest. For example, traders who snapped up stock in UK housebuilders in the aftermath of the EU referendum vote could have made a tidy profit. Following the surprise Brexit vote in favor of leaving the EU, Moody’s put the UK on a negative outlook and with fears of a looming recession, UK builders lost a quarter of their value. All the doom and gloom came to nothing and the UK economy has grown in the last two years, so if you had invested, you could have made a killing. Interestingly, trading bots did better than human traders, as they were less risk-averse. This proves that algorithms often trade smarter because they ignore market sentiment.
Tip #4: Always have a trading plan/method that you follow that details when and where you enter and exit the markets. And always follow it! Having a set of rules that determine when it’s time to get into a trade and when it’s time to exit it allows you to have a calm, systematic approach to the current market conditions. This helps when the market lacks clarity and you’re unsure what to do. Stick to your system, allow it time to prove itself profitable or not and then adjust it accordingly.
Take Advantage of Opportunities
Forex traders were among the few who anticipated huge market swings post-Brexit. Some put restrictions in place for GBP and EUR pairs; others lowered leverage and increased margin requirements. Learn to recognize opportunities when they arise. It’s also worth utilizing losses for tax purposes. You can use any losses you make to offset other income.
Buy and Hold
Risk-averse traders often adopt a ‘buy and hold’ strategy. Rather than making short-term investments, they look for stable products that offer consistent earnings. This approach can work well in a volatile market since most stable companies will remain largely unaffected by short-term volatility.
What You Need to Watch Out For
Trading in volatile market conditions is a very different animal. There are some key things you need to watch out for, which can catch even experienced traders out.
When all hell is breaking loose, and the markets are in freefall, you may have difficulties accessing your online trading account. Don’t rely on an online account to make trades. Make sure you have telephone access to your broker. That way, you can still initiate orders.
Volatility will cause higher than usual volumes of trades, as people seek to cash in on rising prices, or limit their losses when prices are falling fast. When this happens, market prices may change while orders are being executed, so be aware that your order may be executed at a different price to the one you were quoted, especially if you are using an online trading platform.
Volatile market conditions can lead to incorrect quotes and price discrepancies. Your trade will be executed, but when the market is moving fast, the price you actually get may be substantially different. In these trading conditions, it is a good idea to place ‘limit orders’. These set the price at which you buy or sell, which protects you against significant price gaps.
Volatile markets are often a cue for traders to play it safe, but you can make good returns if you have a stomach for risk and are willing to accept that you may lose your capital in pursuit of higher gains. For this reason, if you decide to trade in volatile markets, it is essential that you have a sensible trading plan. And once you have a plan, stick to it, stay disciplined, and don’t panic.