Avoiding a wipeout when trading in volatile markets

AFTER the last few weeks, traders could be forgiven for wanting to shut themselves in a dark room and hide under the duvet. We have had a downgrade of the government debt of a financial superpower, talks of Switzerland resorting to pegging its currency to the euro, and French and Italian authorities banning short-selling. Among other “lowest in decades” and “record high” news, US consumer sentiment is at its lowest since May 1980. But for those who do not want to cower beneath the bedding, how should you approach trading in current market conditions?

According to Autochartist chief executive Ilan Azbel: “My favourite is to use chart patterns in a swing trading strategy.” That is, not to trade breakouts through support or resistance, but rather to trade movements between support and resistance levels. “If pursuing such a strategy, it is vitally important that one is not trading in a trend. So one’s outlook as to the duration of the volatile market is important.”

The pioneer of swing trading was William Gann in the 1930s, racking up huge profits using swing charts. Swing traders try to profit from the upswings and downswings of the markets, identifying the top of a rally and then selling at troughs. Of course this is easier said than done. So how do you identify when these swings will occur? A good method is to use indicators such as the relative strength index (RSI) or the moving average convergence divergence (MACD). The RSI helps to identify when a stock is overbought when it is above 70 or oversold when below 30. In current markets, traders must of course pay attention to their use of stop losses. Not to put them in place would be foolhardy, but under volatile conditions, stops shouldn’t be set too tight to avoid being stopped out too early.

As well as swing trading, Azbel suggests that traders unsure of which way the price will go can employ a straddle option strategy, where an investor holds a position in both a call and put with the same strike price and expiration date. “If the trader knows the point at which volatility will occur (for example a news release) then straddle-options can be highly effective – but of course such strategies reduce upside for the sake of risk mitigation.” This is because on stocks that are to see large movements, the market tends to price options at a higher premium, meaning that the stock needs to move significantly to see any returns.

And if all else fails? According to Azbel: “The last option is of course to stay out of the market – a trader is sure not to lose any money, but won’t make any either.”