What every trader needs to know in the new era of volatility

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Central bankers fought hard to dampen economic and financial market volatility in the post-GFC world.

Low interest rates, unconventional monetary policy, quantitative easing, forward guidance and Mario Draghi’s “whatever it takes” speech were all designed to stop the financial system, and by extension global economy, from imploding.

They were designed to dampen volatility.

On markets it has worked spectacularly well with the free money and QE driving stocks in many cases to all-time highs. No matter the economic outlook, stocks have ripped higher.

But like King Canute, central banks can only hold back the tide for so long. As 2014 was ending, volatility started to re-emerge.
Oil has halved, copper has dropped from the low $3 region to $2.60 a pound, the Aussie dollar fell to 76 cents and the Euro dropped below 1.11 against the US dollar. Bonds across many nations have rallied to unprecedented low yields.

Of course we can’t forget the earthquake that hit foreign exchange markets when the Swiss National Bank decided to ditch the EURCHF peg.

And then there’s the potential impact on markets of the election of Syriza in Greece, if a deal to renegotiate or extend the current bailout package is not reached.

While these big moves in currencies, bonds and commodities have not impacted stock indices the reaction of those stocks exposed to these big macro swings has been an increase in the volatility in their share price.

It feels and looks like volatility has shifted to a new level and that is both a blessing and a curse for traders.

How this volatility affects you depends on how you trade.

The first thing to know is that volatility is like the weather. There are good times and bad. Sometimes markets get storms where volatility clusters and big moves can happen. But for the most part it’s blue or cloudy skies.

But whether there are a number of ways to approach trading in 2015. Indeed I have used these simple ideas for more than 20 years now across a large number of asset classes and markets. They work just as well when I’m trading Aussie dollars, gold, oil or the ASX.

They’ll be just as applicable across CFDs and other leveraged products as well.

Leverage: The greater the leverage – or the smaller your deposit – the smaller the move needs to be to materially impact the capital you have in your trading account if you make a loss.

If you have $10,000 in your trading account and you trade a $100,000 position you are leveraged 10 times. The market needs to lose 10% to wipe you out. Or with your 10 times leverage the market only needs to move 1% against you on 10 trades and you’ll be wiped out. That may sound small, but say you lose on your next three trades at 10 times leverage – that’s 30% of your capital gone. So as volatility rises your leverage should be adjusted downwards to reflect the higher risk of taking a larger hit to the capital in your trading account

In the example above if you reduce your leverage from ten times to 5 or 2 times your risk of losing a large chunk of trading capital falls materially. But, a singular focus on leverage misses the key point on how volatility affects your trading. Sure, volatility is important to how much money you can make, or lose. But rather than think about leverage and volatility as two separate things a smart trader, one who wants to stay in the game, and be profitable over the long run, will combine the two.

Position sizing is the key to long term sustainable and profitable trading. Sure we all want to earn a quick 10 or 20% but that’s not going to happen too often on one trade. In fact for many traders that’s not going to happen often in a year of trading.

By judicious guarding of capital in their account a trader’s job is to build wealth, and his trading account, slowly. And then keep it.

Position sizing is key to this.

What position sizing does is reverse the focus from “what leverage do I use?” to “how much of my account will I risk?”

Now you’re trading.

Here’s what I do.

I start with the premise that I am happy to risk between 1-2% of my trading account on a trade. But, that hasn’t told me how big my position is supposed to be.

So what I do is I use the average of the current daily range for the past 20 days (what in the game is called the average true range or ATR in the chart above) and then I work out what position size I can run that will risk 1 or 2% of my capital if there’s a move against me of 2 times the ATR.

For CFD traders the way you adjust your position size is to round the number of contracts you are trading to a number of contracts that, with your stop in place, will represent the potential loss of 1-2% of capital.

Smaller accounts using mini-contracts do the same thing.

Looking at that Aussie dollar chart above intuitively you’re probably thinking this process looks a bit troubling when the volatility spikes (ATR rises) like it did from September to November.

But the reverse is actually true.

Because volatility was lower when a position was entered into, I’ll have smaller stops, closer to market, as volatility rises. This means that if a big adverse move hits I’ll get stopped out faster.

Sure I’ll still lose my 1 or 2% of capital I have at risk. But I’m out and I’m not fighting the market making the mistake of holding on to losing trades for too long.

So many times I’ve seen this happen and suddenly one trade has cost a trader 10 or 20% of his capital.

This is the key to position sizing. It forces you to put your stops in place at the same time you enter the trade.

Now you are trading risk, not risking trades.

Trading risk is what trading in a volatile environment is all about.

But there is one more little trick you need to use.

Traders who are learning their craft often let their losses run and cut their profits short.

Trailing stops: Trailing stops move higher as the market moves in your direction. You can still use an ATR measure – or whatever your system suggests. But the key here is in a volatile market you can be in and out of the money very quickly.

So a trailing stop can help retain profits.

Volatile markets can also be associated with big trend moves, as we have seen this year in BHP (not to mention the Aussie dollar, Euro, Crude Oil and so on.)

So traders have to master the hardest thing any trader is likely to face: staying in a profitable trade.

That’s a difficult psychological hurdle during volatile times. But while there is never a guarantee of success hopefully the ideas above can help traders trade better in this year of volatility.

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