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Trading Volatile Markets

Trading Volatile Markets

2011-03-17 00:00:00
Jeremy Wagner, CEWA-M, Senior Strategist
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The USDJPY exchange rate moves to a new record low in the midst of increased volatility. When the 3rd largest economy of the world was hit with the terrible earthquake last week, an already skittish market began to unwind its carry trades.

Volatile markets occur as a result of temporary dislocations of capital. That means the scale of buying volume versus selling volume is off balance. Therefore, prices move erratically until a new equilibrium is reached.

Many traders see a large amount of capital returning to Japan through relief efforts, aide, and paid insurance claims. Therefore, this influx of capital is strengthening the JPY driving the USDJPY exchange rate down to record lows. When you have significantly more sellers than buyers, equilibrium is off balance and the exchange rate moves very quickly.

Trading_Volatile_Markets_body_Picture_1.png, Trading Volatile Markets

So how do we navigate these volatile markets?

First, it is reasonable to expect volatility to continue in the near future. Volatility of the USDJPY, gauged by the ATR (Average True Range – blue line at the bottom of the chart), is at its highest level since June 2010. As a matter of fact, when prices entered that period of volatility on May 6, 2010 (also referred to as the day of the Flash Crash), 14 of the next 23 trading days experienced a daily range of 100 pips or greater. Therefore, we can look for elevated levels of market activity in the next couple of weeks as prices seek out a new equilibrium level. In my opinion, traditional strategies of support/resistance and breakout strategies tend to perform well during times of volatility.

Regarding the risk management on the trade, we need to latch onto 2 key principles to help protect the balance of your trading account during this potentially volatile stretch.

  1. Consider widening stops to accommodate the increased volatility by a factor of 2 or 3
  1. Risk less on your open trades

For example, if you like to trade breakouts with a 40 pip stop loss, look to widen the distance of the stop loss to 80 – 120 pips. Since widening your stop could impact your risk to reward ratio on the trade, I would look to manually move your stop as the price moves in your favor. A good rule of thumb is that if price moves half way to your profit target, then you can move your stop to break even.

How can we risk less on the open trades while widening our stops? Good question. Risk is a function of your trade size. You can widen your stop AND risk less by reducing your trade size. For example, a trader may risk 2-3% of the balance in volatile markets rather than 5% in calmer markets. Let’s look at a specific example. Assume the trader has $20,000 in the account.

Non-Volatile Market Condition

Volatile Market Condition

Starting Balance

$20,000

$20,000

Percentage of Risk

5%

2%

Risk of Balance

$1,000

$400

Lots Traded

$1,000 / 40 pip stop = $25/pip or

25 LOTS

$400 / 80 pip stop = $5/pip or

5 LOTS

An obvious result is the difference in trade size. Remember, volatility is a temporary dislocation of capital. Many times, volatile markets speed up the results of your trade. Therefore, you may be trading in a lower trade size, but the market may also offer you more opportunities over the coming days than you typically trade.

Times like these are very exciting for traders. On many occasions, traders will be willing to give up some sleep to capture the increase in trading opportunities. Keep your emotions in check and trade well!

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