Four skills for trading when volatility is high

Philip Salter
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A VOLATILE market can be an unforgiving beast, swinging wildly from bull to bear, as animal spirits rampage and investors take flight. The Vix index – a measure of market fear – broke through 40 yesterday, its highest reading since 25 May 2010, indicating that we are living once more in volatile times. Following the US downgrade and given the ongoing Western debt crisis, things won’t calm down any time soon. In these troubled times there are fortunes to be made, but also to lose, making the discipline of following a trading strategy essential.

Founder of Malcolm Pryor says the first question traders need to ask is: “How do we measure volatility?” He recommends an off-the-shelf solution for technical analysts called Average True Range (ATR). Pryor explains: “ATR measures the average distance between the high and the low of each period over a user-defined number of periods – although the actual calculations are more complex.” On the last trading day of July it was 78, but by 4 August this had increased to 107 after some large down days.

Volatility takes different forms. If markets are trending significantly in either direction then riding these waves from peak to trough can be profitable. However, volatile market conditions can also be remarkably choppy, turning on a sixpence before a trader has time to jump on a trend. A stuttering market turning in short timeframes leaves no trend to be your friend, stopping out usually successful strategies.

In a capricious market, setting the right stops becomes vital. Pryor says the most important task for traders is to adjust their stop size to reflect current market conditions. He explains that a day trader using a fixed stop size in all market conditions is likely to get stopped out of positions too early when volatility increases. It also makes sense to use trailing stops to lock in gains. Angus Campbell of London Capital Group notes that yesterday the FTSE opened over 100 points lower, then rallied to post a 50 point gain, but soon after posted a 50 point loss. Campbell cautions: “When you open a position you could be looking at a decent profit, before the market simply whipsaws in the other direction, leaving you looking at a loss.”

When the walk of the markets appears more random than normal, it is no dishonour to take your skin out of the game and wait for things to settle down. But volatility has a tendency to pull traders into the heat of battle. Campbell says: “During volatile times we see trade volumes pick up substantially, as clients attempt to profit from the sharp and big moves in the markets.” But traders should be aware that despite the potential for profits, the bull and bear can come back to bite them. Campbell cautions: “While volatility can present opportunity, it is also a tricky time to trade the markets.” As such, unstable markets are not the place to cut your trading teeth, yet with discipline and the right techniques it is possible to move with the money.