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To a greater or lesser degree all financial markets are volatile to a certain point. Extreme volatility however, while less common, can occur in the stock market in particular. Being able to survive and manage market volatility is a very important skill and strategy to hone as a financial trader and investor.

Understanding market volatility

The term volatility refers to the varying degree of changes of a particular security or financial asset prices. In general, the higher the volatility the more a trader stands to profit or lose. In other words as volatility increases so does risk.

Volatility in the stock market

In the stock market, prices are considered volatile when they rise or fall in excess of 1% over a limited period of time.

As a statistical measurement, volatility is often determined by the standard deviation or variation between returns of a particular stock. Other calculations include option pricing models and beta coefficients.

How to trade in volatile markets

Volatility cannot be avoided but it can be mitigated with a strong and informed trading strategy. If your plan does not take into account extreme volatility you could find yourself risking high losses or even being stopped out of a position.

Access to markets

If you’re considering investing or trading in an extremely volatile market you need to be able to adjust to sudden changing market conditions. Without having agile access to markets and trading you’ll miss both opportunities to save and make money. You cannot reduce and manage market volatility without access to the market.

Liquidity and capital

Extremely volatile markets move, by definition, at a very fast pace. Changes to the global or even local economic or political landscape can drastically and dramatically shift prices in a market. Without access to the required capital and liquidity, you may not be able to take advantage or even react to breaking news and extreme volatility.

Stop loss

Once you have determined the level of risk you’re prepared to take you can implement a stop loss. This measure will ensure that your position on a particular stock is automatically stopped if it should drop to a specific price level.

Position sizing

The term position sizing refers to the amount invested into a particular asset and should reflect risk tolerance and access to capital. Experienced and knowledgeable traders understand that a high exposure-to-margin ratio, while it can pay handsomely, can end up costing you a lot of money. Your stop loss will help you determine your position sizing, and both will be a reflection of the amount of volatility you’re expecting or anticipating in the particular market.

Gapping

The term gapping refers to a stock (or any financial instrument) opening at the beginning of a trading day at a price level above or below where it closed on the previous day. Hence, the ‘gap’. The volatility in gapping is intensified by the fact that no trading has occurred between the end of the previous trading day and the opening of the new one. When stock trading in a volatile market, your risk management plan will need to take into account potential gapping overnight and especially over weekends.

Understand volatility

Volatility cannot be controlled or prevented, but it can be used when understood to your advantage. Afterall, you won’t know how to trade in volatile markets without understanding volatility first.

Technical indicator monitoring

Technical indicators can be used as a series of tools to help you identify and determine the extent of volatility in the stock market. Two of the more helpful and popular technical indicators include:

  • The Average True Range - The ATR is used to determine the movement of a stock’s price on average over the course of either a three or five day period. Naturally, this means drawing from historical data. Using the ATR can help you decide where to place your stop loss and what level of risk you’re willing to take on in your position.
  • Bollinger Bands - Bollinger bands indicate the amount of movement in a price of a 20 day period through a moving average. Naturally, the larger the ‘band’ the more volatility in price there is. Consequently, you’ll want to reduce the size of your position if the risks are increased. Most movements in price occur within two standard deviations, so movement beyond this either up or down is considered volatile.

An important point to note is that neither of these technical indicators provide information as to whether the price of the stock will increase or decrease. It merely indicates the average movement one way or the other of the asset over a defined period of time.

Instrument variation

The average daily moves in a particular financial instrument can vary. Each instrument works independently, is affected by a conflation of factors and is to be used in a particular way. That’s why not only do you need to understand the amount of leverage in a particular traded asset but also the different leverage degrees in each instrument.

Conclusion

While we’ve tried to cover some basic and high level ways in which you can survive extreme volatility in the stock market, knowing how to manage market volatility is a complex and ever-changing skill.

Of course, there are strategies and tactics to help you reduce risk and exposure in the face of volatility and getting your head around these will help you understand how to trade in volatile markets.

Did we miss something you were hoping we’d cover? Let’s continue the conversation. Contact Global Prime today with all your trading and financial market questions.