Mon, Jan 18, 2021 @ 02:08 GMT
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Five Ways to Survive in Extreme Volatility

When we combine leverage and incredible movement in financial markets, we need to adapt our approach. Otherwise, we run the risk of either being stopped out or in line for a loss that could be disproportionate to our account size.

When we anticipate greater movement in an instrument, the first thing we need to do is understand how much risk we’re prepared to take in every trade. The best way to define this is through the placement of our stop-loss.

Gapping as a consideration

Obviously, gapping is a concern here, which is why we need to consider the risks of holding our positions through periods such as weekends when markets are closed and we can’t react in real time. However, the stop loss is there to guide our expected risk on each position.

Position sizing is the key

Subsequently, the distance to the stop loss should define the position size, and this needs to be proportionate to the account size. If you have a $1000 account it isn’t recommended to put down $900 as margin on a EURUSD exposure when you have leverage of 500:1 – it could work out well, or it could result in a margin call on this small account in a short period, especially in a fast-moving market.

Position sizing, especially in a highly volatile (vol) market, is what separates the pros from green traders. It’s the utmost consideration and the backbone of any disciplined trading plan, for those wanting to survive in high vol periods, let alone growing the capital in the trading account.

Your trading guide to harnessing volatility

When our primary job as a trader is to manage risk, we need to understand how movement and implied movement in price impacts our trading, let alone our strategy, so here’s a quick guide on how you can better harness volatility.

  • Use technical indicators to monitor volatility

Realised volatility is simply the extent and the magnitude by which a financial market moves from a predefined mean. It’s a statistical fact and can be very helpful for traders. Two of the best-known indicators we can use are Bollinger bands and the ATR (Average True Range).

Bollinger Bands

Bollinger Bands represent the extent to which price moves from the 20-day moving average. The wider the bands, the greater the movement or distributions in price from this short-term mean, and the more we need to consider reducing our position size.

Statistically, we know that 95.4% of moves in price are contained within the upper and lower bands (i.e. two standard deviations). Our clients will often use the lower band as a guide to near-term downside risk in a strong sell-off and we will see price hug the band in a powerful move

Average True Range (ATR)

In a fast-moving market, it is best to use either the 3- or the 5-day ATR to assess the degree and average movement in the daily true ranges. Context is key, and while we not only look at the level of the ATR in relation to a prior period (say the past 12 months), we also look at the absolute level and use this to define our risk.

On any timeframe, the ATR offers a guide as to how far away the stop loss should be placed. When we know the distance to the stop (our risk), we can achieve correct position sizing. In the above example, the 5-day ATR for USDJPY sits at 210 pips, so we would ideally leave our stop at least 210-pips away from the entry. This is a sizeable amount of risk to take should you hold the position until the stop is triggered, so we would reduce our position size accordingly.

Key takeaway: taking on more risk and not reducing your position size can be a disaster waiting to happen.

Many will go even further, maybe, leaving a stop 1.5x ATR so as to give enough breathing room. So in a market with very high realised vol this just increases the risk even more and is a huge amount of risk to take, especially for a small account.

  • Choose your instrument wisely

Individual financial instruments have their own characteristics, and each come with their own typical degree of movement.

For example, the average daily moves in the NASDAQ 100 tend to be greater than the S&P500, while the average moves in the Nikkei 225 are often larger than the ASX 200. We see this at a currency level, with AUDJPY often having far more powerful moves than AUDNZD.

Therefore we need to be aware not just of leverage in the product, but the fact that there are differing degrees of leverage in each instrument.

Most traders are taught to put 1% or 2% of their account equity on each trade – I feel this is too rigid, and we should adjust, not just for volatility, but by the instrument itself.

  • Volatility is agnostic on direction

A high ATR or Bollinger Band doesn’t try and predict direction, it just portrays the extent of the move in price. We use vol to help stay in the game and manage position size, not to assess entry points

  • Lifestyle considerations

Fast-moving markets mean you need to change your lifestyle and trading behaviours. In a market, with extreme volatility, we see wild swings and often on little news – if you’re not in front of the screens you can’t react with the same agility. If you can’t get in front of the screens you put yourself at a disadvantage. Traders react to price moves.

  • Liquidity as a core consideration

In a fast-moving, intense market, market makers and liquidity providers may not offer the same level of deep pools of liquidity and this can only exasperate moves, especially around key announcements or a major market-moving headline.

In high vol periods, we often see the market craving for information to provide answers to whatever the economic, geopolitical or liquidity crisis is. This is a dynamic where headlines drive significant price shifts and can be problematic for retail traders who are up against news recognising algos. Twitter can be a great source of information.

Let’s recap

This list should offer some guidance on how you can better trade high vol markets. I haven’t focused on implied volatility, which is something I look closely at in my Friday ‘Trader’s week ahead guide’. And, while there are other realised vol measures, it’s important that you remain smart, alert and retain your edge to help stay in the game through high vol period. The best way to stay in the game is to adapt – meaning not only getting the direction of the trade correct, but also accepting not every trade will be profitable. If you can respect leverage and extreme volatility, obtain a more precise measure on risk, achieve correct position size and manage the losers correctly, you’ll be well on your way to surviving in times of extreme volatility.

Pepperstone is authorised and regulated by the Australian Securities and Investment Commission (ASIC) and the Financial Conduct Authority (FCA). We take pride in our strong culture of regulation and compliance. The security of our client funds is of paramount importance. Pepperstone maintains segregated client accounts with National Australia Bank (Australia) and Barclays (UK).

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