How To Turn Volatility In Your Favor
After about a decade of being an active participant in the financial markets, I can say that the volatility is pretty high. This one reason why only select individuals decide to enter the business of active trading, let alone attempt a career in it.
Forex volatility, along with that of futures and equities, can make sustaining a living in the markets a monumental task. However, it can be managed, and even turned in your favor.
What Is Volatility Trading?
Sometimes the markets go quiet for multiple sessions or days. This may give you the impression that it’s easy to trade forex — but then hundreds of pips move in just a few hours! In order to navigate the periodic chaos of the currency trade, it is important to understand the differences in forex volatility.
When it comes to volatility trading, there are two types to be concerned with: historical and implied. Historical volatility is the normal price action over a period of time (i.e. a month or a year). Conversely, implied volatility is any abnormal current or future price action. When compared to historical price action, implied usually exceeds the historical range. So, we´ll refer to implied volatility in this article.
Forex volatility can be dangerous but nice profits are possible if you play your cards right.
FX Leaders’ Forex Volatility Trading Checklist
We can overcome market volatility. In fact, we can even turn it in our favor and take advantage of some big moves. Through all of the years that I have been a trader, I have come up with some rules to avoid getting caught offside and reap the benefits of volatility trading. So, here we go:
The most logical thing to do when the market gets agitated is to widen your take profit/stop loss targets. There are three basic types of behavior exhibited by volatile markets and the subsequent price action:
- A volatile market may run for hundreds of pips in one direction without looking back
- It might run for hundreds of pips in a choppy price action, making deep retraces after every leg
- It might move quickly up and down within a defined range
In each type of volatile market, you’d better increase your stop loss and take profit targets if you want to survive. This way you avoid the negative impacts of whipsawing and minimize your losses while increasing your profit potential.
Widening the targets helps avoid getting whipsawed.
Sometimes when volatility is large and price action choppy, it is wise to use small stops and big take profit targets. This volatility trading technique usually gives the best results when applied to ranging markets. It looks contradictory to the other technique above, which discusses the widening the targets – but it actually works!
When the price has established a range and is trading inside it, you need to put the stop close above the top when you sell and below the bottom when you buy. You never know when the price is going to break out of the range and how far it will run when it does. So on these occasions, it is better to keep a tight stop loss.
Remember when EUR/USD was trading between 1.05 and 1.1050 after the FED meeting in March? It was moving 400-500 pips up and down in a couple of sessions. When it finally broke the top of the range, price jumped to 1.1450. If you had placed the stop 100, 200 or even 300 pips above the top you would have ended up with a big loss after the breakout — a common occurrence in volatile markets. Even if you get stopped out a few times, you can more than compensate for the losses with a winning trade.
Lower Your Leverage
Leverage is very useful for traders aiming to make large profits with a limited amount of their own capital. However, leverage is also one of the main killers of trading accounts. So, if you are widening the stop loss target using a volatility trading plan, you better also lower the leverage. At the end of the day, your account risk must remain at the same ratio as during normal times.
A few weeks ago, when the Chinese stock market tumbled, the moves in some forex pairs were as huge as 600 pips in just a couple of hours. We decided to enter long USD/JPY after the first 200 pips decline. We opened a buy trade with 300 pip targets for both the take profit and stop loss. Little did we know that the pair was going to move another 400 pips down.
If we had applied the same leverage of 3% for a 30 pip stop loss, we would have lost 30% of our account in one trade. But we lowered the leverage from 1:10 to 1:2 and lost 2% of the account.
We recovered it later that day as the price moved back up with another buy trade from the bottom, as you might have noticed from our signals. Had we kept the leverage the same and lost 30% of our account, we would have taken a harsh blow. It is highly likely that we wouldn’t have been able to open a second position to return our loss on the first trade.
You cannot beat the entire market, so it’s better to lower your leverage during high volatility.
Diversify Your Portfolio
Portfolio diversification is one of the main techniques to survive over the long run. Large institutions always diversify their portfolios with many instruments in many different markets.
Diversification takes on an extra importance when the volatility is high. You can never be 100% sure of the outcome of a trade under normal trading conditions. In periods of high volatility, the uncertainty increases. So, spreading the funds you usually trade into several pairs and in different directions will limit your risk and frequently bring in a nice profit.
Diversification becomes even more profitable when the price is choppy amid increasing forex volatility. If you sell EUR/USD near resistance and buy AUD/USD near support when the wave of strength in USD is coming to an end, then you might end up with two winning trades. In the worst case scenario, you´re just hedging your losing trade and eliminating its losses. If you do that with multiple pairs, some of them will bring in profit while others break even.
Look At The Bigger Picture
A volatile and choppy market often gives you the impression that it is moving around with no clear direction, leaving you puzzled. That’s why it is better to look at the bigger picture in order to avoid being influenced by the noise in the smaller time frames. This way you can see the more important support and resistance levels of the higher time frames, which will stop you from overtrading the smaller time frame indicators.
Overtrading, especially in a volatile market, is as bad as high leverage. If you open too many trades you cannot concentrate and nurse your trades properly. Logic becomes blurred and it is difficult to get a clear direction. Therefore, it is best to observe the market on larger time frame charts to pick the best entry spots.
How many times have we heard the phrase “patience is a virtue”? Patience is essential when volatility trading. So, pick the important levels in higher time frame charts, then wait until the price reaches this level and strike. When you have made enough profit on your trade, get out. Rinse and repeat.
For more tips of trading in a volatile market: How to Trade Profitably in Volatile Markets – Forex Trading Strategies
When In Doubt, Stay Out!
Last but not least, practice avoidance when appropriate. You don’t always have to be in the market. You cannot grab every single pip that the price makes when moving up and down. You´re trading to make a profit, so it is ideal to wait for the best opportunities.
When you’re unsure which direction the market will go, it is best to stay away and simply observe the market until a good opportunity comes along. There will always be one — don’t go chasing after the price in a volatile market!