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How Traders Can Take Advantage of Volatile Markets

Volatility presents different opportunities

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How Traders Can Take Advantage of Volatile Markets

In order for anyone to make money in the financial markets, there must be price movement. Fortunately, price movement is a constant in the markets. There are however, different degrees to which price movement may occur. Sometimes the tone of the market is relatively quiet. There may be a few leaders and laggards that are experiencing outsized moves, but overall the majority of stocks are not making big moves. Sometimes the market may be moving slowly and quietly in one direction, or it might be trading within a relatively narrow price range.

On the other end of the spectrum, there are times when prices overall are moving at an above-average rate of speed. The rate at which price movements occur serves as a good working definition of the word “volatility” as it applies to the stock market.

The good news is that as volatility increases, the potential to make more money more quickly also increases. The bad news is that as volatility increases so does risk. To put it as simply as possible, if you are on the right side of a move during a volatile period you stand to generate an above-average profit within a below average period of time. Unfortunately, the same is true if things go the other way. In other words, in a volatile market environment, you may also run the risk of losing a great deal of capital within a relatively short period of time.

The keys to taking advantage of volatile markets are:

  1. Understanding the potential benefits and risks.
  2. Developing a strategy to increase potential while limiting risk.

Step #1 — Define your objectives and define what you are willing to risk

Define your objectives

Increased volatility by definition indicates that prices are rising or falling at a higher than average rate of speed. This implies higher potential and higher risk. It is quite possible that the majority of investors and traders view “volatile markets” as a good time to “play it safe.” In other words, it can be argued that acting to minimize risks when things are at their most volatile is a prudent strategy. And for many individuals this may be true. But the point of this article is to detail the possible actions that a trader can take if his or her goal is to profit from an increase in volatility. So the first step is to make sure that:

  • You are comfortable playing the markets when volatility is high.
  • That your primary goal is in fact to maximize profitability.
  • You recognize that there is the potential for significant loss of capital and are willing and prepared to accept this risk.

Assuming you are "ready for action", the next prudent thing to do is to revisit the risk control measures that you have as part of your trading plan. Two important considerations are position sizing and stop-loss placement. During volatile markets—when day-to-day price swings are typically greater than normal—some traders will prefer to trade a smaller size (i.e., commit less capital per trade) and to actually use a wider stop-loss than they would when markets are quiet. The goal is to avoid getting stopped out due to wider than normal intraday price fluctuations, while attempting to keep overall risk the same (in other words, a smaller position with a wider stop instead of a larger position with a tighter stop. As always, traders should note that stop orders can be executed far away from the stop price if there is a price gap or fast market conditions.

Step #2 — Adopt a High Volatility Strategy (or Strategies)

Adopt a strategy

The final step is to adopt a trading strategy that can actually take advantage of an increase in price volatility, while also taking steps to limit risk as much as possible. While there is no “one best way”, let’s look at several avenues a trader may pursue.

1. Focus only on stocks trending in the primary market direction
If the stock market is trading strongly within a defined trading range, then a counter-trend strategy—i.e., buying when support holds and selling and/or selling short when resistance holds—might make sense. However, one key opportunity in trading volatile markets is that stocks that are trending may actually see the rate of their trend increase as overall market volatility increases. This means that looking for stocks that are already trending in the direction of the overall market may afford a trader the opportunity to generate profits more quickly than they might during normal, quieter markets, albeit with a potentially higher degree of risk as mentioned earlier.

This approach is typically used by technical traders who look at charts to identify trends. The key to utilizing this approach is to find a stock that has been trending higher (if the stock market is in an uptrend) but which has not yet accelerated the pace of its advance. A short seller trading in a volatile market should look for a stock that has been declining but which has not already experienced a “collapse” or “waterfall” decline. The goal is to get in before an acceleration in price, not after.

2. Watch for breakouts from consolidations
One common trading method used by many traders is “buying the breakout”. With this approach, a trader monitors a stock that is trading within some identifiable support and resistance range. As long as the stock remains within that range, no action is taken. However, if the price breaks out to the upside, the trader will look to buy the stock immediately in hopes that the breakout signals the beginning of a new up-leg for the stock.

In quieter markets, a stock may breakout to the upside and lose its momentum, drifting sideways or eventually falling back below the breakout level. However, in a volatile market, where prices are moving rapidly, an upside breakout can be followed by an immediate and substantial run to higher prices. This type of potential is the primary reason to trade breakouts in a volatile market environment. The catch is that in a volatile market a reversal from a false breakout can come very quickly and the subsequent price decline may be more severe than during a quieter market environment. As a result, a trader who chooses to “buy the breakout” in a volatile market should seriously consider a stop loss-order to attempt to cut his or her loss either after price falls a certain distance back below the breakout point, or will limit the loss to a particular acceptable percentage amount.

3. Consider shorter-term strategies
Another approach that traders utilize when markets get volatile is to adopt a shorter-term trading strategy. This typically involves attempting to take profits—or at least lock in profits—more quickly than normal. Consider the example of a trader who typically buys stocks as they breakout above resistance. Typically, after entering a trade, this trader places a stop-loss X% below the entry price and then waits for a profit of at least Y% to accrue before activating a trailing stop. As the stock rises in price the trailing stop will also rise, thus locking in an ever-greater profit.

As mentioned in the discussion of breakouts, in volatile markets, profits can accrue quickly following a breakout. However, reversals can also be swift and severe. Profits can vanish and previously profitable trades can turn into losers very quickly. For this reason, some traders will consider taking profits more quickly when volatility is high via:

  • Setting a specific percentage profit target.
  • Selling part of a position at the first good profit-taking opportunity and holding the remaining position in hopes of generating additional profits.
  • Using an overbought/oversold type indicator (RSI for example) and selling when it signals that the security is overbought.
  • Activating a trailing stop sooner than normal and/or using a tighter trailing stop than normal. In some cases a trader may need to need to monitor price action in order to effect a trailing stop as the trailing stop order is not available on all Schwab platforms, only StreetSmart Edge.

Summary

Traders crave price movement as price movement is what offers them an opportunity to profit. But at times, price movement can accelerate beyond what they are used to. A driver traveling 100 MPH has the potential to reach his destination more quickly than a river traveling at 60 MPH. However, the first driver must be prepared to deal with all that comes with traveling at such a high rate of speed. The same is true for traders. When market volatility reaches a certain level, things can start to move so quickly that different tactics may be in order. The key is to prepare in advance. The tactics discussed in this article should serve to give you some potential ideas to consider.

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