To make money in the financial markets, there must be price movement. Fortunately, price movement is a constant in the markets, and one key factor is how rapidly prices are moving. The speed or degree of change in prices (in either direction) is called volatility.
The good news is that as volatility increases, the potential to make more money quickly also increases. The bad news is that higher volatility also means higher risk. When volatility spikes, it may be possible to generate an above-average profit, but you also run the risk of losing a larger amount of capital in a relatively shorter period of time.
With a disciplined approach, you may be able to manage volatility for your benefit—while minimizing risks. Here are four steps to consider when trading in volatile markets.
1. Define your objectives and bolster your defenses
Before attempting to trade in volatile markets, be sure you are mentally and tactically prepared to manage the increased risks involved. So, the first step is to make sure that:
- You’re comfortable trading when volatility is high.
- You recognize the potential for significant loss of capital and are prepared for this additional risk.
Assuming you’re “ready for action,” the next prudent thing to do is revisit the risk-control measures you have as part of your trading plan.
Two important considerations are position size and stop-loss placement. During volatile markets—when intraday and day-to-day price swings are typically greater than normal—some traders place smaller trades (commit less capital per trade) and also use a wider stop-loss than they would when markets are more calm.
The goal with these two adjustments is to attempt to avoid getting stopped out due to wider-than-normal intraday price fluctuations while attempting to keep your overall risk exposure about the same. As always, traders should note that stop orders can be executed far away from the stop price during a big price gap or during rapidly changing market conditions.
2. Focus on trending stocks
Despite higher overall market volatility, there may still be stocks that exhibit strong trending activity—albeit with a potentially higher degree of risk. For a buyer, the key to this approach is finding a stock that’s been trending higher but which hasn’t accelerated the pace of its advance.
Likewise, a short seller trading in a volatile market should look for a stock that’s been declining but which hasn’t already experienced a collapse or “waterfall” decline. The goal is to get in before a price acceleration (or collapse in the short seller’s case), not after.
3. Watch for breakouts from consolidations
One common trading method used by some traders is “buying the breakout.” With this approach, a trader monitors a stock that’s trading within an identifiable support and resistance range.
As long as the stock remains within that range, the trader does nothing. 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.
4. Consider shorter-term strategies
Another approach that some traders use when markets are 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 usually buys stocks as they break out above resistance. Generally, 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, which is a conditional order that uses a trailing amount—rather than a specifically stated stop price—to determine when to submit a market order.
The trailing amount, designated in either points or percentages, then follows (or “trails”) a stock’s price as it moves up (for sell orders) or down (for buy orders). As the stock rises in price, the trailing stop will also rise, thus allowing the trader to potentially sell at a higher price.
But in more volatile markets, when profits can suddenly vanish and turn into losses, you might consider making the following adjustments to exit the trade faster:
- Set a specific percentage profit target.
- Consider selling parts of your position should it rise quickly, and hold the remaining position in hopes of generating additional profits.
- Enter a trailing stop order sooner than you usually might and/or use a tighter-than-usual trailing stop price.
Traders crave price movement as it offers them the potential opportunity to make bigger profits. But at times, price movement can accelerate beyond what they’re used to.
With volatile markets, stocks can start to move so fast that closer attention and a change in tactics may be necessary. The key is to prepare in advance.
The steps discussed in this article are no guarantee to keep you on course, but they’re worthwhile if you’re ready to take on volatile markets.
When in doubt, wait it out
If you’re not sure where the markets are heading, just sitting on the sidelines isn’t a bad idea. Periods of heightened volatility come and go and—more often than not—are short-lived, so sometimes, the best trade to make may be no trade at all.