Trading tips for volatile markets

How day traders can navigate volatile markets

Even with extensive experience and a solid, well-planned trading strategy that has been developed over time and also rigorously tested, trading is still often difficult. As a trader, volatility is important, it is why we are involved in markets, to take advantage of regular daily and intraday price swings.

However, even the most seasoned trader or investor might find successful trading and investing challenging when markets enter into a more volatile phase. We are going to look at what an increase in volatility means, as well as what we can do to make the most of the situation.

In this post we will take a look at:

1. What is volatility in financial markets?
2. How to measure volatility
3. Is volatility a good or bad thing for day traders?
4. Fleeting vs sustained volatility
5. What to avoid doing in volatile markets
6. Tips for trading volatile markets
7. Key takeaways

What is volatility in financial markets?

Volatility is a statistic that measures the propensity of a market or security to rise or fall, with increased volatility highlighting a market that is rising or falling more rapidly than usual.

It is usually defined as the standard deviation of an investment’s return.

The amount of variation (or dispersion) that may be expected is represented by the standard deviation.

Volatility within a market is characterized by changes in price over time, that are both large and unpredictable. But it helps to remember that volatility is not always a bad thing.

Measuring volatility

Note: This section is a little more technical, so if mathematics is not your strong point, you can skip it, but I’d like to take a quick look at the VIX contract, or the ‘fear’ index as it’s known in capital markets.

There are numerous ways of measuring volatility, which again is a measure of how much a financial market changes in price. An example might be the S&P 500 index, which has an annual standard deviation of between 2% and 10%.

One of the most common measures of volatility for stocks is the VIX index, which is a measure of how much investors are pricing in market volatility for the S&P 500 index. It’s an important tool used by traders to determine how volatile the US stock market is, as well as simply just checking the mood around Wall Street!

The VIX is officially the CBOE Volatility Index and is often called a “fear gauge” as it reflects market sentiment and worries.

Without going too deep into the mathematics of the VIX index, it is basically a measure derived from options prices on the S&P 500, by averaging the weighted prices of out-of-the-money puts and calls. This all sounds very technical, and for the more curious amongst you, can learn more here.

But suffice to say, that the higher the VIX reading, the more volatile the S&P 500 is, reflecting the broader US stock market.

Daily VIX price, Dec 2021 – March 2022

Is volatility a good or bad thing for day traders?

Volatile markets are seen as riskier, but they can also present greater opportunities. Even though high volatility markets might be difficult to trade, you can plan your trading strategy around it by considering the change in the potential market movements and the variation in the risks involved.

Not only can volatility be an opportunity for traders, it can also present challenges. When you are looking to take advantage of volatile shifts in the market, the biggest challenge may be getting caught up in short-term volatility without having adequate time to develop your strategy.

When a market is more volatile it is typical to see bigger fluctuations in the price, and very often (though this is not necessary), larger trading volumes.

Volatility is usually fleeting, but it can become more persistent when markets are in an uncertain state. This may be because of a brief macroeconomic event or the release of important data by policymakers – such as interest rates announcements from central banks.

Fleeting vs sustained volatility

Sometimes though, markets can go into a period of sustained, increased volatility. This can be driven by uncertainty in economic prospects for one economy or even the global economy.

An example would be the early 2022 increased volatility as the US Federal Reserve and other global central banks (including the Bank of England and European Central Bank) shifted to a more hawkish tone due to increased inflationary concerns.

In addition, an increase in volatility may also come from an unforeseen external stochastic shock caused by geopolitical events which make traders and investors feel like the world isn’t as safe anymore. Again, early 2022 provides an example with the increased volatility across financial markets because of the tensions between Russia and Ukraine.

Increased volatility can make trading and investing even more difficult, but not unmanageable. Remember, with the rise in price movement, there is the prospect for larger profits. But traders must remember that this should be balanced against the threat of possibly larger losses.

What to avoid in volatile markets

• When markets start acting volatile and are not moving the same as we are used to, moving “oddly”, traders can easily become quickly overwhelmed. This can then lead to making irrational decisions. So, one of the first things to do is to take a deep breath and assess the current situation, maybe exit traders that are losing money, and take a break before trading again!
• A mistake traders often make during increased volatility in markets is wanting to increase their trading activity (the frequency of traders) and to also increase the size of their positions. Traders often become excited, see the potential for big profits with faster-moving markets and therefore increase their risk-taking. This is a significant risk for traders. Remember, the increased volatility should permit you to make larger profits anyway, from wider, more volatile price movements; therefore, you DO NOT need to do trade more often or trade bigger size in a more volatile trading situation.
• You know that old saying “don’t risk more than you can afford to lose“? Well, it’s true in both life and trading. When things are volatile, traders often feel their emotions getting the best of them – which doesn’t help at all! What happens then? You often start to chase losses instead of closing out positions entirely and taking a break from your trading. Otherwise, you may end up losing way more money than during those times when prices were less volatile.

Tips for trading volatile markets

• The stop-loss is a critical tool for managing risk in the markets. It should be set wide enough to protect capital but not so much that you’re taking unnecessary risks. With increased volatility markets tend to move more aggressively, so it is often necessary to widen out the stop-loss placement.
• Even though a wider stop-loss may be required, this does not have to mean that your Risk Reward Ratio should suffer. As well as a wider stop-loss, the volatile conditions should also allow for a larger potential target to be set. Often, traders minimally look for traders with a Risk Reward Ratio of 2:1, but it could be possible to aim for a larger Risk Reward Ratio in more volatile markets.
• After considering the potential for a wider loss on our stock-loss placement and for a larger initial target level, it then makes sense to reduce position sizes. So, for example, If you decide that doubling your stop-loss position is necessary, then halving your position size is the next logical step, to ensure that your total risk on the trade in absolute terms (in monetary terms) is the same. A key part of making sure trades go as planned lies in reducing how much capital goes toward each trade, by appropriately scaling down risk levels based on current volatility conditions.
• Volatile periods can lead to different price action in a market, which means that your entry points and stop losses from your usual strategy may change as well.  You do not have to completely abandon your successful trading approach, but you will likely want to take a look at this strategy and asses it, and analyze risk management processes in case it is not adapting well to the increased volatility. An updated (not necessarily new) plan should be considered for more volatile trading conditions.

Key takeaways for volatile market trading

1. Reduce your trading size, this is the critical takeaway!
2. Look at widening out your target levels and stop-loss levels, reducing your trading size allows for this.
3. Review your trading approach and strategy, stay calm and stop or pause trading if need be.