How To Turn Volatility In Your Favor
Skerdian Meta • 5 min read
After about a decade of being an active participant in the financial markets, I can say that the volatility is pretty high. This is why not everyone decides to enter this business or attempt a career in it. There are two types of volatility: historical and implied volatility.
Historical volatility is the normal price action over a period of time (i.e. a month or a year). Abnormal current and future price action are called ‘implied’, and when compared to the historical price action it usually exceeds the historical range. So, we´ll refer to this type of volatility in this article. Sometimes the market goes quiet for multiple sessions or days and this may give you the impression that it´s easy to trade forex. But then hundreds of pips move in just a few hours!
Volatility is dangerous but you can bring in some nice profits if you play your cards right.
FXL's Volatile Markets Forex Trading Checklist
We can overcome market volatility. In fact, we can even turn these volatile markets in our favor and take advantage of the big moves. Over all the years that I have been a trader, I have come up with some rules to avoid getting caught offside by volatility and even reap the benefits. 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 types of price action during volatile times; 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, or it might move quickly up and down within a range. In all these types of volatile markets, you’d better increase your stop loss and take profit targets if you want to survive. This way you avoid whipsawing. This minimizes your losses and increases your profits by widening the profit potential.
Widening the targets avoids getting whipsawed.
Sometimes in a volatile market when the moves are large and the price action is 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 rangy 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. Then it broke the top of the range after some time and 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, and breakouts are very common in a volatile market. Even if you get caught out a few times, you can more than makeup for the losses with a winning trade.
Lower your leverage
Leverage is very useful for traders to make large profits with a limited amount of their own capital. But leverage is also one of the main killers of forex accounts, especially during volatile times. So, if you are widening the stop loss target in such markets, you better do your calculations right and lower the leverage to the correct amount so the risk remains at the same ratio in your account 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 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. If we had kept the same leverage and lost 30% of our account, we would have received a harsh blow and it is 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
Diversification of your portfolio is one of the main techniques to survive in the long run. The large institutions always diversify their portfolios with many instruments in many different markets. Diversification takes on extra importance when the volatility is high. You can never be 100% sure of the outcome of a trade during normal times. During times 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 often bring in a nice profit.
This becomes even more profitable when the price is choppy. 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 choppy market; the sell EUR/USD position during the leg down and the buy AUD/USD position on the leg up is the way to go. In the worst scenario, you´re just hedging your losing trade and eliminating its losses. If you do that with several pairs some of them will definitely bring in profit, while others will end up 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. Your logic becomes blurred and it becomes difficult to get a clear direction. Therefore, it´s best to hold on and observe the market in 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 trading in a volatile market. 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, avoidance. 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´s best to wait for the best possibilities as we explained in the above section. When you´re unsure which direction the market will go and don´t know what to do, it´s best to stay away and just observe the market until a good opportunity comes along. There will always be one, so don´t go chasing after the price in a volatile market.