Volatile markets strike fear into many value investors. However, traders who can utilize these markets will find themselves enjoying a distinct advantage over those who shy away from them. So, how do day traders and long-term investors alike take advantage of volatile markets?
To start, they understand their risk tolerance and clearly define their strategies to protect themselves from losing too much money. Their clearly defined methods include using limit orders and setting stops on their positions.
This blog discusses volatility and how investors use this market condition to their advantage. It examines the indicators used to determine volatility and strategies that help investors determine optimal entry and exit points for their positions.
Price Action and Income provides traders with daily knowledge that aids their trading strategies. Our educational videos, trade forecasts, and methods will help traders of all experience levels boost their portfolios and achieve sustainable returns.
What Is Volatility?
Volatility describes the likelihood of a market or security rising or falling sharply in the short term. The standard deviation- a statistical representation of the expected variation or deviation within the market or security- typically measures volatility.
For example, a particular market or security might have a standard deviation of about 15 percent. A more stable investment would have a lower standard deviation because the return varies less frequently.
Wide price fluctuations and high trade volumes characterize volatile markets. In volatile markets, trade orders often occur disproportionately in one direction (all buys, no-sells, or the other way around). Some analysts suggest volatile markets occur as a result of economic releases, company news, analyst recommendations, highly anticipated initial public offerings (IPOs), or unexpected earnings results. Day traders, short-sellers, and institutional investors can also cause volatility in markets.
Analysts speculate that psychological forces can cause market volatility. Conversely, the efficient market hypothesis (EMH) suggests that market prices are correct. And they adjust accordingly to all relevant factors. The theory posits that price changes occur in tandem with the collective shift of the investing public’s mind.
These differing schools of thought point to the absence of a clear cause for volatility. However, despite there being no apparent cause of volatility, there are proven ways to succeed in volatile markets.
A popular measurement for volatility is the VIX index from the Chicago Board Options Exchange (CBOE). The Vix index measures implied stock volatility on a 30-day scale using the S&P 500’s strike prices for call and put options. The VIX is known as the Fear Index and investors widely consider it the best volatility indicator for US markets.
Investing in a Volatile Market
The easiest way to avoid losing money in volatile markets is to avoid them altogether. Avoiding volatile markets can be a critical component to a successful long-term strategy. For example, if you’re a value investor, you typically try to avoid volatility. Value investors favor markets with established price patterns.
Avoiding the pitfalls of volatility takes grit and it also requires ignoring significant price fluctuations. Buy-and-hold strategies also take diligence. Just because you hold a stock for twenty years doesn’t guarantee you a return. Value investors study corporate fundamentals, looking for consistent balance sheets and short-term fluctuations, reducing risk.
Choosing Order Types in Volatile Markets
Choosing your order type can make or break your portfolio when investing in volatile markets. Market orders are always executed, which can spell doom in fast-moving markets. It takes time to execute market orders, and if a market swings before your order gets filled, you could wind up paying substantially more for your order than anticipated.
That’s why limit orders make sense in volatile markets. Limit orders place a predetermined price on your order, meaning you won’t pay for the order if the price fluctuates above your specified price. These orders cost a little extra, but they assure you don’t spend more than you want for securities. However, because they lock a buying price, you might not always fill your orders.
Volatility Provides Opportunities for Day Traders
Many analysts view volatility as a sign of market health for both long and short-term investors. Long-term investors might feel uneasy in volatile periods, but volatile times are necessary to reduce outsized returns.
Systemic risk is an integral component for markets and that risk is a critical piece of favorable stock performance and increased returns. Investors who can take advantage of the risk in volatile markets stand to achieve higher returns, regardless of whether they are short-term or long-term investors.
You can see this law at work when you examine day trader strategies. By leveraging tools such as moving averages, traders can identify ideal entry and exit points for trades. For day traders, the direction of the move is less relevant than the range of returns on the volatile asset.
Day traders can also examine the average true range, which tells them the average daily price fluctuations of a stock. An average price fluctuation of $1 is a good indicator of volatility.
4 Tips for Trading in Volatile Markets
Whether you’re a short-term or long-term trader, there are a few tried and true methods for investing in volatile markets. Using limit orders, keeping your costs low, aiming for the highs, and setting firm boundaries for losses and gains help you succeed in volatile markets.
Use Limit Orders
Traders who succeed in volatile markets are successful because they understand how to mitigate risks. If you want to have success as a day trader, you need to know how to minimize your risks. You can reduce risks by setting your day trading time frames.
Another easy way to reduce risk is through the limit order. Buy slightly above the market price and you’re contributing to the trend, not leaning against it. When you buy at the market price, you can suffer instant loss, or you might just be flat-out wrong.
Keep Your Costs Low
High-frequency traders benefit from bid-ask spreads being tighter and trade executions being better during highly volatile days. The friction traders have to overcome to execute orders is less. For example, in the past, stocks would have to move at least a half-point, if not an entire point in your favor. Now, you can make substantial gains if the stock moves a nickel in your favor.
When considering high-frequency trading in volatile markets, consider how much you lose to commissions, taxes, and other fees. It’s not about the money you make while day trading. It’s about the money you keep.
Aim for the Highs
Institutional buyers step in when companies experience a new high on their stock price. Traders in high volatility markets should scan for 52-week highs and range-bound stocks breaking above their trading range.
When these stocks break out of their range, they reveal ideal entry and exit strategies for day trading, and as institutional buying accumulates, so does momentum and stability.
Set Firm Boundaries
After making money on a position, many traders fall victim to the idea they can make more. When high-frequency trading, set a boundary and stick to it. An example of a sound exit strategy is the cup-and-handle strategy. In the cup-and-handle, a stock might fall and trade in a consolidated range. Then it will return to its original pullback position. As long as the stock market is flat or rising that day, day traders can benefit from this pattern.
Suppose a stock starts the day at $10 and falls to $8. Later, the stock returns to its original position at $10. Finally, it breaks past its original trading price to $12, representing an ideal exit position. However, if the shares stay flat throughout the day or move higher, and the volume stays consistent, it would signal to day traders to hold.
In this scenario, to avoid losing a substantial portion of the principal, a seasoned day trader would set a stop at $7. The point is to be prepared to walk away with a profit and not risk losing your principal for sentimental reasons.
Conclusion- How to Succeed in Volatile Markets
People might associate volatile markets with risk. While volatile markets are risky, they present higher earning opportunities, making them attractive bets for traders who know how to identify optimal entry and exit points.
Traders who take advantage of volatile markets have various attributes in common, including analyzing price action indicators, avoiding emotional trading, utilizing limit orders, and setting boundaries for both earnings and losses.
At Price Action and Income, we believe eager traders should have access to knowledge that will help them uncover valuable trading opportunities and strategies. Our series of educational videos and ebooks can help you understand when to enter and exit your positions and get you on a path to sustainable portfolio success.
Contact us today to find out how we can improve your portfolio.