Market volatility frightens investors. Large share price moves, fragile markets and sharp reversals of fortune make for nervous days and sleepless nights. Yet volatility is the traders’ friend – fast moving markets offer more and larger trading opportunities. These potentially higher rewards come with increased risks, and demand that experienced traders recognise and adapt to changing market conditions.

Historic Stimulus Programs

History will judge whether the major central banks “saved the world” with their unprecedented monetary stimulus programs. Launched in the wake of the Great Financial Crisis (“GFC”), success of these programs requires not just flooding the banking system with money and dropping interest rates to zero, but the eventual withdrawal of the extraordinary accommodation. This is the long term risk. The stimulus programs are a method of borrowing growth from the future. At some stage, this growth must be repaid, and the injected funds and low interest rates withdrawn. The concern is that the world is now condemned to decades of low growth as the debt to the future is repaid, and this long term drag on prosperity brings ever increasing risks of a deflationary spiral that ultimately destroys asset prices. This is both an extreme scenario and a real possibility. Traders looking at hourly charts rarely think too hard about the markets ten or twenty years down the track. However, those who are making money have already adapted (consciously or not) to the changing market conditions engineered by reserve bankers.

Market Conditions

Market conditions are always evolving. Longer term volatility charts suggest the effect of the combined actions of the US Federal Reserve (Fed), the Peoples’ Bank of China (PBoC), the European Central Bank (ECB) and other national banks effectively threw a blanket over markets. The huge pool of funds made available meant investors and traders became wary of selling, but were not yet confident enough to buy boots and all. The implications for volatility are obvious. In the second quarter of 2014 currency and index volatilities hit lows not seen since the 1970’s. By July, US SPX 500 Index 60 day volatility dropped to 7%, the lowest level since the GFC peak at 75%. This occurred as all central banks poured liquidity in the one direction, creating a single global current that lifted prices. Now, with the Fed and Bank of England (BoE) moving towards withdrawal as the ECB, PBoC and Bank of Japan (BoJ) continue pumping stimulus, the currents are crossing, forming eddies and waves that make markets much more choppy trading environments. Naturally, this is pushing volatility levels back up. Given the likelihood of further shifts in central bank thoughts and actions, traders may wish to consider strategic responses to both lower and higher volatility environs.

Strategy - Trading Lower Volatility Markets

Lower volatility means less trading opportunities, and more “failed” trades. A common strategic trading mistake under these conditions is to start trading new techniques, or using “gut feel”. These departures from a trading plan usually cost significant amounts in the long run. Rather than lower trade selection quality controls, traders can consider whether their trading techniques are applicable in other markets. Accessing more than 10,000 instruments on a single trading platform means every trader has room to expand their trading influence. Lower volatility usually means choosing nearer price targets that have the potential to reduce overall profitability. Traders can offset these lower value opportunities in two ways. The first is to bring stop loss orders closer to the trade entry point. This preserves reward/risk ratios, and is particularly useful when traders choose to expand their trading universe. The second choice is to increase trade sizes, making more profit from smaller market moves but this also has the added risk of potential losses.

Strategy - Trading Higher Volatility Markets

The imperative of highly volatile markets is to identify and capture as many trading opportunities as possible. Traders must bear in mind that risk management in trading is always important, but never more so than in highly volatile markets. A single missing stop loss order can severely dent trading capital. As volatility increases traders may do well to check their risk management techniques. This may mean placing more stop loss orders, or different stop loss orders, such as trailing stops and guaranteed stops. Traders find more opportunities in volatile markets. Like a child in a sweet shop, this can lead to salivation and indecision. A rational response when faced with more options is to reduce individual trade sizes. Often, the amount of capital committed to the market increases, but overall risk is lowered as the trading is diversified over more instruments. Finally, bigger market moves could potentially mean larger trading profits as traders aim for more ambitious targets. However the downside to that would mean “staying in the trade” is tougher in choppier conditions. Traders can utilise the greater profit potential by also moving stop losses away from entry points, once again preserving reward/risk ratios. Email: marketcomment@cmcmarkets.com Follow CMC Markets on Twitter: @cmcmarkets Follow Michael McCarthy (Chief Market Strategist) on Twitter: @MMcCarthy_CMC CMC Markets is an execution only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.