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Trading in Extremely Volatile Market Environments

Trading in Extremely Volatile Market Environments

Jeremy Wagner, CEWA-M, Head of Education

Talking Points

-How markets become disorderly creating volatile pricing

-Potential triggers for future event risk

-6 risks that grow prominent in an extremely volatile market environment

Over the past several years, we have seen some extraordinary events rattle markets and spark volatility to extremely large levels. For example, back on January 15, 2015, Swiss National Bank removed their peg on EUR/CHF causing the exchange rate to move 40% in a matter of seconds. To put this into perspective, the equities flash crash in May 2010 saw the Dow Jones Industrial Average move 9% in minutes. So a currency move of 40% in seconds was unprecedented.

Another example was when markets were freezing up in 2008 due to Lehman’s bankruptcy, GBP/JPY moved over 2,000 pips from high to low on October 24, 2008 which is about a 13% drop. Though warning signs existed of troubled times (in retrospect), when the fire gets hot markets can move quickly and disorderly.

How can markets become disorderly in such a short amount of time?

FX pricing is derived through the interbank market. In the interbank reference market, you have institutions trading liquidity on hard rates (not indicative quotes). As these transactions take place, their price is marked and essentially produces a ‘feed’ of pricing. You may have heard of the EBS feed or Reuters feed. This is referring to the interbank reference market.

The disorderly movement and subsequent volatility results from the interbanks becoming uncertain of the events taking place. They become risk averse and less aggressive on the pricing, or perhaps pull their available liquidity altogether.

As the interbank marketplace dries up, any transactions taking place could be many pips away from the previous pricing level.

If the event is unprecedented or really extreme, few transactions are taking place at the interbank level. The interbanks simply don’t know how to price the risk in the market and would rather wait for clarity. In the SNB example, the market was so one sided in that there was a flood of interest in buying CHF. The interbanks didn’t know where to make their market, so few transactions were taking place and the market froze.

Though the retail trader doesn’t participate in the interbank market, the liquidity and pricing available to them is a function of the interbank market. Many institutions rely on the EBS or Reuters feed to help them make a market. If the interbank market is frozen, then these institutions that rely on the interbank price feed freeze up as well. The freeze becomes widespread and the freeze sprawls out towards the retail client.

This could lead to a temporary loss of order flow and transactions for several minutes, which means a temporary loss of indicative quotes for the retail client.

This all starts with an unprecedented event that shoots demand towards one side of the coin.

In retrospect, we can place a name to certain events and see the trigger. Events similar to above are likely to happen again in the future, though with a different name attached to it. When you look around at potential triggers, events like the EU Referendum vote for United Kingdom (popularly known as the Brexit vote) comes to mind. The days leading into the event could potentially be volatile. It is possible we could see banks pull back quoting while votes are being tallied. Other potential events may include bankruptcies to oil industry firms that may take a large bite out of those banks holding a lot of energy based debt. Or, perhaps we see an emerging market crisis develop resulting from the hawkish interest rate policy from the Fed. Also, don’t rule out China setting a new path for their exchange rate that could cause a disequilibrium of capital.

The point is regardless of whether we ‘predict’ the event or not, the anticipation for extreme volatility in the near future is increasing. We can begin preparations now for how we would trade through extremely volatile environments. In short, it is during those volatile markets that traders need to consider altering their approach to accommodate for risks that may be forgotten or unanticipated for during the calmer trading environments.

We are going to cover 6 risks that grow more prominent in extremely volatile market conditions. We’ll follow up each risk with suggestions on how to handle them. This will allow traders the ability to start preparing should volatility spark to extreme levels.

1. Price Gaps

A news event may take place on a weekend that can push prices significantly in one direction. The market is constantly moving even though a trader’s access to that market may be limited at certain times.

As a result, there is a risk that prices gap and move quickly. This most frequently happens over the weekend and during news events. However, it can happen anytime.

Therefore, the best way to manage this risk is by avoiding weekend exposure, avoid trading exotic markets, and avoid trading through major news events.

Read more about price gap risk.

2. Liquidity Thins

During times of risk aversion, the depth of available pricing begins to thin. The resulting illiquid conditions makes it difficult to get into and out of positions without taking a hit on the price.

Some markets tend to be more liquid than others. Therefore, carefully choose a market that tends to be more liquid. These include, but are not limited to, EURUSD, USDJPY, and GBPUSD, which are 3 of the more liquid FX markets. Stay away from exotic markets. Markets such as ZAR, HUF, and CZK may see an imbalance of trading on the bid and ask which could make it difficult to trade.

Lastly, while in trades, maintain conservative amounts of leverage or no leverage at all. Providing a cushion of usable margin may help prevent a margin call when the interbank market place pulls back its liquidity.

Read more on liquidity risk.

3. Increased Margin Requirements

Increased margin requirements is a safety mechanism for brokers and banks to cushion against volatile market conditions. When volatility increases, there is an increased potential for larger market movements, illiquid markets, and gaps. These scenarios pose a greater credit risk to the price makers and greater risk to the trader through negative balances. Brokers don’t want to be on the hook for your losses so they manage the risk through margin increases.

Since margin requirements can be increased without warning, manage this exposure by avoiding markets with a known event risk taking place. Also, steer towards the more liquid major markets for trading as their margin increases are likely to be less than exotic markets. Major markets include, but are not limited to, EURUSD, GBPUSD, USDJPY, USDCAD, AUDUSD, Oil, Gold, US30, SPX500, and GER30. This is not an exhaustive list and even these markets can see increased margins, so use your discretion.

Read more on increased margin requirements.

4. Spreads Widen

When banks become fearful or uncertain, they pull in their quotes which causes the reference and benchmark rates to widen out on the bid and ask. As these spreads widen, it gets passed along into the retail market.

The first point of action is to avoid participating in markets with a known event risk coming up. It may be enticing to see large candles appear on the charts, but recognize that not every one of those prices were executable. Getting out of a trade can be difficult, especially if it is an exotic market or less liquid market.

If you do plan to trade a more liquid market, consider using market range orders. These orders control slippage of the trades and will only execute within the desired range of prices.

Keep in mind that if you are trying to exit a trade while gaps and slippage are high, implementing a market range order does not guarantee order execution because the price could slip outside of the prescribed range. Therefore, you may be stuck in the trade you are trying to exit. The best line of defense is to reduce the exposure when feasible. Otherwise, consider using market range orders.

Read more on spread risk.

5. Rolls Widen

The rollover rates are a tradeable market that tracks interbank lending rates. During normal market environments, the rollover rates tend to be stable without significant fluctuation from one day to the next. If the interbank market becomes stressed due to risk appetite falling, then it is possible to see the rollover rates swing drastically from day to day.

The good news is that rolls are only applied to positions held open at 5pm ET. Therefore, avoiding the risk of worsening rolls is easy to do by making sure positions are closed prior to 5pm ET. For day traders, this solution is simple and probably doesn’t affect you as much because you are likely flat on positions at the end of the day anyway.

Read more on rollover risk.

6. Certain Strategies/Studies Fail or Underperform

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

  • Unresponsive
  • At risk of breaking down

During volatile markets, oscillators can provide many false signals. Place more weight on price action studies rather than a lagging oscillators.

Additionally, 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.

Read more on strategies/studies failing.

There are some items regarding trading that you have control over. One of which is the effective leverage you decide to implement (if any) on a given trade. We studied millions of live trades and distilled them into our Traits of Successful Traders research. One this we uncovered is that profitability declines substantially as effective leverage increases: 40% of traders using an average effective leverage of 5:1 or lower turned a profit while only 17% using 25:1 or higher closed at a profit. Read more about this on page 10 of our 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.