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Trading in Volatile Market Conditions: Certain Strategies Fail

Trading in Volatile Market Conditions: Certain Strategies Fail

2016-06-16 13:32:00
Jeremy Wagner, CEWA-M, Head of Education
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As we begin the last segment of our 6 part series, this section will be devoted more to market analysis during volatile trading conditions.

When markets get volatile, some strategies and technical studies become:

  • Unresponsive
  • At risk of breaking down

If you trade with a common indicator like Relative Strength Index (RSI),stochastics, or MACD during an extremely volatile environment you’ll find those indicators won’t be as responsive as pure price action analysis. That is because these indicators are essentially fancy moving averages which were designed to smooth out market fluctuations. It is that smoothing technique which forces the indicator or oscillator to lag the market. If you are lagging the market, then you are making trading decisions now based on old price action which could be drastically different.

Changing the input value of the indicator or oscillator to increase its sensitivity helps a little, but the challenge remains in that the whole idea of the oscillator or moving average is to smooth out price. During normal markets the common indicators are useful. During volatile markets, they can provide many false signals. Place more weight on pure price action studies rather than a lagging indicator.

Many traders employ a buy low and sell high range type of strategy. During many market environments, this can be fruitful as we found out in our Traits of Successful Traders research. However, in extremely volatile market environments, range strategies are at risk of breaking down and underperforming as fear enters the market, banks scramble to protect their balance sheet, and traders exit positions creating price swings that could break support and resistance levels. Therefore, avoid range trading strategies, but consider breakout strategies during a volatile market environment.

To build on that thought, developers of algorithms typically create a strategy that works well in the current market environment so they can deploy the strategy immediately. Therefore, the Expert Advisor (EA) in use during normal market conditions, is at risk of underperforming during volatile conditions. Strategies are designed to do well in a certain type of market environment. Therefore, you may consider turning off your current EA and use a different EA trading strategy when markets become extremely volatile.

What type of strategy should you consider turning on? Well, two types of strategies come to mind. Take the spirit of what these two strategies offer when considering extreme market conditions.

The first is focusing on price action strategies that don’t rely on oscillators. So, using candle patterns like engulfing candles, hammers, or the various star patterns. Also patterns such as triangles, head and shoulders, and wedges are examples of price driven patterns that can be used.

The second strategy is breakouts which is the opposite of a range strategy. You see, volatile markets tend to produce new price extremes above resistance or below support as the supply and demand becomes dislocated. Therefore, if we wait for those price extremes to occur and trade in the direction of the break, then we are aligning ourselves in the direction of the short term trend.

We studied a Donchian Channel Breakout strategy which trades purely based on price action. One thing discovered is that if we employed a volatility filter to the strategy, the raw performance improved. As a result, we can draw the connection that when markets become volatile, implementing a breakout type of strategy allows the market to dictate to you when it may be ready to trade to new extreme levels.

If you are not sure how to implement a breakout strategy, we have some resources to help you get started:

4 Step Guide to Trading Breakouts in Forex

Implementation of any strategy in volatile market conditions needs to be taken under consideration of the risks cited earlier. One benefit of trading breakouts is that you can set the entry orders in the platform so you don’t have to be present when the break occurs (see 4 Step Guide to Breakouts).

However, that entry order comes with a risk that is accentuated in volatile conditions…slippage. Volatile market conditions are associated with fast moving markets. Therefore, your entry order is a stop order that executes at the next best available price which could be several points away from your entry price. You can control the amount of slippage through a range entry order. Generally speaking, be careful and choose markets that are more liquid and trade during times of day when more liquidity tends to be available.

Lastly, as should be the case with any strategy, make sure to utilize conservative amounts of leverage or no leverage at all. We researched over 12 million trades and found that traders who utilized less than 10x effective leverage were on average more likely to be profitable than traders who implemented more than 10x effective leverage. Read more about this particular trait in our Traits of Successful Traders Research.

Remember that trading on margin can result in losses that could exceed your deposited funds and therefore may not be suitable for everyone, so please ensure that you fully understand the high level of risk involved.

See Jeremy’s recent articles at his Bio Page.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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