5 Tips for Trading a Volatile Market
With the markets showing extreme volatility as of late and higher beta growth stocks leading the way lower recently I thought I’d share some ideas I try to use when markets get volatile. It never really matters why volatility happens as it usually shows up the same way technically if you are a chart watcher. Trends begin to break down below key moving averages like the 21 and 50 day moving averages. Then the average true range starts to increase along with implied volatility of options (think VIX) as the markets start to price in higher volatility. You often can sense the character of the market shifting well before big momentum reverses into a downtrend so its useful to always be on alert for the potential risks as the market tends to warn well in advance with signals such as internal market breadth and key sectors moving before the broad market succumbs to a change in market forces. As a swing trader I prefer holding positions overnight for several days to several weeks if the market is allowing for that but when things change here are some of the rules I try to focus on most.
1. Trade Less
In a volatile market it might seem like there is so much more to do with stocks moving wildly hitting prices that were unimaginable before the volatility came about but that is exactly when it’s best to focus on less total trades. Fewer trades open allow you to have more mental clarity when it’s needed most. There is nothing worse than having too many positions in the wrong direction when the market makes an unexpected turn and intraday ranges increase drastically. Taking into account a market that might have the SPY moving 3 points in a normal market day you might get 3 times that range intraday when things turn volatile. Pick your spots during the week to attack the highest probability support and resistance levels which offer the best risk/reward to enter a trade. With prices moving in so much greater speed and overall price ranges higher, it doesn’t take many trades to reach a solid profit if you are disciplined to trade less. Trading less can keep your mind clear and unbiased when markets get wild and you will feel that much more calm if you wake up to an extreme gap down instead of worrying about how much you might lose on existing positions. I’ve learned the hard way that it rarely pays to have many positions on overnight when volatility increases, especially when the VIX is sustaining levels above 25-30. A VIX at that level implies nearly a 2% intraday range being priced in and that can easily occur overnight subjecting traders to gap risk. There will be plenty of time to trade more when the market storm passes, it always does, so focus on staying liquid without being a nervous wreck.
2. Focus on Index Liquidity
When volatility increases, that means correlations increase and nearly every stock moves with the stock indexes. Since the futures dictate on where the overall market goes, most stocks will get dragged in that direction with it. So why try to bother finding stocks and looking through a ton of charts when you can just focus on trading liquid index ETFs. When market volatility increases I try to focus on trading SPY or SPX options. QQQ and IWM are also nice alternatives as both are extremely liquid and offer great options markets. There is nothing worse than being bearish and correct but the stock you chose to short or buy puts on got upgraded or had a buyout rumor that saved it from dropping while the overall market went lower as you expected but you tried to be cute and pick a stock instead of just trading the broad market index. I’ve seen it happen several times. Also the other risk in trading markets with wild volatility is the fact that bid/ask spreads on options can often be wider and less accommodating on certain stocks that might be normally liquid in a calm market. If you just trade index ETFs like SPY, QQQ, IWM you will avoid that liquidity risk and give yourself a fighting chance to catch a nice momentum move without having to worry about slippage or a bad fill, on entry and exit.
3. Trade Smaller Size with Wider Stops
One thing that messes up a lot of newer traders is trading the same position size and risking the same amount per trade in a highly volatile market as they would in a normal market. If the SPY generally moves 2 points in normal market conditions but then the VIX spikes from 15 to 25 then that intraday range is not going to be just 2 points anymore. It might be 6 or even 10 points from high to low. This means that you are going to experience a large change in your account volatility if you don’t adjust your trade size as well. If I am usually risking 2% per trade in average market conditions then I will cut that in half at least to allow myself breathing room with the increased intraday ranges. Better yet, scale into positions at the smallest increments because you are surely not good enough to catch the exact high or low of a move when volatility spikes, no one is. Cutting your position size in half is a great way to survive markets that start moving at speeds you aren’t used to.
Also in addition to smaller size it helps to increase your stops or levels where the trade is invalid. Because if the options market starts to price in 2% moves per day, you want to give yourself as much room to be correct as possible since the ranges are larger intraday but you want to be realistic as well. Assuming you aren’t scalping day trades, you want to look at the average true range (ATR) and be at least outside of that number if you plan to hold a stock overnight. If the ATR is 7 points and you’re running a stop that is 3 points, you will be stopped out, period. Give yourself some room for the trade to play out and you can likely have a decent chance at making something. I’ve always found it much better to simply cut your position size in half and double your stop.
4. Use Option Spreads
On the topic of stops I prefer to use options and more so options spreads in more volatile markets. The advantage being that you know your max risk on an option trade when you enter and overnight gap risk isn’t as huge a concern since you defined your risk with the option. Of course you can still operate under the plan of only risking 50% of the option you bought which is always a fine way to manage risk. The other way I like to trade options in volatile markets is to buy or sell spreads which takes away a lot of the vega of volatility crush risk in a trade. If you buy a call option in a very high VIX environment and the market rallies slower than you expected, you probably don’t end up making as much as you hoped because the VIX crush that occurs after a big panic is substantial and the premium comes out of the option. Unless you time things perfectly and you get a very strong move up, it often can be best to trade vertical spreads or call butterfly spreads in higher volatility markets. You take away a lot of the theta decay component and also combat the IV crush that hits long option holders. Another great way to trade is using credit spreads or selling naked puts. In higher volatility you get paid more for selling options. If you are experienced and understand the risks involved with selling premium then these are some of the best opportunities to enter into cash secured put sales or general credit spreads that benefit from a directional move with implied volatility declining.
5. Take Profits Faster
The final thing to focus on is one I am trying to get better at myself. Take profits faster when you get the move you wanted, especially if it’s a large move in one day. Often day to day moves are random in higher volatility. The market might trade up off the lows 3% one day and close at the highs only to then gap down 2% the next day. More volatility means more moves faster. So if you make 50% in one day on an option, take it. The market is offering up a gift. Make 25% in an hour? Sell and move on. There is nothing wrong with taking profits much faster in this kind of wild market so if things are going well on a trade you put on earlier in the morning and you start celebrating because you were so smart to enter, it’s time to sell. Anytime the market moves drastically in your direction on the same day during an unpredictable environment then don’t start high fiving yourself and think you have this figured out. Take the gain and leave the greed at the table for some other trader to get sucked in by. Volatile markets move much farther up or down than any of us can imagine so the number one job that traders have is to not lose money. If you happen to find profits along the way, then create modest profit targets and honor them. The worst feeling is having a profitable trade in a volatile market quickly turn negative because your price objective was “the moon”. I’ve been there and it’s mentally draining for your focus and motivation. The key in volatile markets is to survive and not drain your mental capital because that is much more valuable than monetary capital when markets go wild.