Market volatility is the upward or downward movement of price in the market. While the market could witness either low or high volatility, both however come with risks and opportunities.
During times of high volatility, currency exchange rates and stock prices can record new highs and new lows and this is where the danger lies. As a trader, you could lose more than you ever anticipated. A currency exchange rate could fall to the lowest it has ever been in the past 5 years, or even a decade.
According to the Bank of England Governor Andrew Bailey in an interview: ‘we’ve had some very big shocks, we’ve had Covid shocks, we’ve now got a shock from energy prices. These are very big shocks, we’re living in an era of very big shocks’
It hard to disagree with him because the Russia-Ukraine conflict has caused energy prices to go up and generally worsened volatility in the markets.
Several factors including political and economic factors, company’s performance, and industry uncertainty can cause market volatility.
Measuring Market Volatility
A credible metric to measure market volatility is the Volatility Index (VIX).
The VIX, also known as the fear index, measures the sentiment of investors who have bought S&P 500 index options. When volatility is high, these investors panic and start buying Options contracts on S&P 500. The VIX gives a projection of volatility in the market for the next 30 days.
The more options contracts that are bought, the higher the VIX index keeps climbing.
Usually when the VIX index is below 20 the market is considered low risk. However a VIX figure above 20 indicates high volatility and risky conditions. As at today the VIX is 29.43 meaning volatility over the next 30 day will be high.
Another way of measuring volatility is via Beta which compares the volatility of the asset in question that of the entire stock market.
A bad situation gets worse
During volatility, traders are confronted with extreme fear as they do not want their open positions to fall into a loss. Some of the pitfalls to watch out for when volatility is high are:
1. Higher transaction costs
Firstly A spread is the difference between the BID/ASK price of an asset. The ASK price is the price your broker is willing to sell the asset to you for, while the BID price is what the market actually thinks the asset is worth and will pay for it.
Spreads usually become wider during periods of high volatility. For example, it isn’t uncommon to see two CFD brokers offering varying spreads on the same currency pair during high volatility.
During high volatility brokers could take advantage to widen the spread- using volatility as an excuse and urge you to buy before the price climbs further.
Secondly, during volatile seasons, you may want to trade more often either to cover losses or to see if you can take advantage of swinging prices to make a profit. Doing this means you pay more fees and commissions and this could erode any profits you make in the end. The brokers smile to the Bank.
2. Exchange rate risk
FX and CFD traders are exposed to the risk associated with the exchange rate.
This is sometimes known as ‘currency risk’ or foreign exchange risk. You stand the risk of experiencing a decreased value if there is a sharp or significant change in the value of the currencies you paired together.
In the forex market you use one currency to purchase another currency.
If the purchased currency pair increases in value, the trader will profit from it, but if the purchased currency pair reduces in value, the trade will be in loss. In the case of high volatility, traders could even record a loss in currency exchange before the transaction is completed.
3. Gap risk
When the markets are highly volatile, prices swing up and down very sharply. This means new highs, and record lows. To counter this you may want to use a stop loss order.
A stop loss is a market order you give to your broker directing him to close your open position as soon as the price of the asset you’re trading crosses a stop price which is set by you.
However the problem is during high volatility the price of the asset may gap or leap past your stop price. When this gapping happens, your stop loss order will not be triggered at the price you wanted. It ends up being triggered at a different price and this causes you to lose more money than you anticipated.
Sailing during a volatility storm
During high market volatility, you should protect yourself from the numerous risks that accompany it. You could wait till the high volatility subsides; but if you desire to trade, you should be cautious and take the following measures:
1. Trade the VIX
Instead of trading risky assets during high volatility you could simply trade volatility as an asset. There are Exchange Traded funds (ETFs) that track the volatility which you can trade.
ETFs can track a particular sector like Tech or an index like the VIX. ETFs are properly regulated since they trade on an exchange just like stocks.
Some of ETFs that track the VIX include: ProShares VIX Short-term Futures ETF (VIXY), and ProShares VIX Mid-Term Futures ETF (VIXM).
2. Use Guaranteed Stop Loss orders (GSLOs)
A GSLO works simply like a stop loss. The unique feature about it is that it will definitely close out a trade at the specified stop price irrespective of market volatility or gapping.
For example, if you are trading GBP/USD exchanging at $1.2503, and you set your GSLO at $1.2500, the position would be closed at exactly $1.2500 irrespective of high market volatility or price gapping.
3. Use take profit orders
A take profit order is a limit order that defines a specific price an asset will rise to (usually above the current market price) before your open position is closed. The idea is to sell before the price starts falling. It helps you manage the emotion of excessive greed.
4. Buy the breakout
If you do your technical analysis of historical market performance of an asset, you will notice a point on the chart where an upward trend loses steam, and begins a downward spiral; this is the resistance ceiling.
There is also a point on the chart where a downward trend gains momentum, and begins an upward ascent; this is the support floor.
A breakout occurs when the price of an asset defies a resistance ceiling and breaks through it or when the price of an asset plunges past a support floor area without ascending as expected.
During high volatility seasons it is best to buy when the price breaks through the resistance ceiling and sell when the price drops past the support floor.
5. Use less leverage
Leverage is the act of borrowing money from your broker to take on larger trade orders. You should not over-leverage especially during high volatility. This will be making a bad situation worse.
An over-leveraged position could expose the trader to overwhelming risk. Your losses will become larger and a margin call may come faster than you think.
In UK, Europe & Australia, leverage is restricted & regulated brokers must follow the leverage restrictions.
For example, the FCA regulated forex brokers are not allowed to offer above 1:30 leverage to retail clients for forex & lower for CFDs on higher volatility instruments like commodities. But research conducted by Safe Forex Brokers UK with data of over 120 brokers showed that there are many unregulated & offshore regulated CFD brokers that accept clients from the UK, and they offer excessive leverage to retail traders, as they don’t have to follow the leverage restrictions.
However, in some other geographies especially Africa and Asia, CFD brokers can offer as high as 1:2000 leverage to clients and this is like playing with fire. It doesn’t end well most of the time.
6. Always calculate your Risk to Reward ratio (RR ratio)
George Soros; the world’s most successful trader famously said: ‘It’s not about whether you’re right or wrong that’s important, but how much money you make when you’re right and how much money you lose when you’re wrong’
RR ratio is a measure of how risky a trade is. It tells you if the reward is worth the risk. When volatility is high, risk is also high so an RR ratio comes in handy so you don’t expose yourself to too much risk.
Risk to reward ratio formula is RR= (Entry point – Stop loss point)/ (Profit target – Entry point)
If you buy EUR/USD at an exchange rate of $ 1.0600 with the hope that you will sell when the price gets to $1.0900, you could set your stop loss order at $1.0400
Your RR = ($1.06 – $1.04)/ ($1.09 – $ 1.06) = 0.6
If you RR ratio is below 1, the transaction is low risk but if the RR ratio is above 1, the risk is more than the reward.
7. Stick to Your Plan
Don’t be tempted to sell your stock and leave the market during periods of high volatility. It’s best to stick to your initial plan because high volatility doesn’t last forever.
Sitting on cash won’t do you any good either because inflation will erode some of the value of the cash. If you are at crossroads as to what to do, you can choose to do nothing and wait it out.
Periods of high volatility are a good opportunity to buy assets at a cheap price so that after the volatility lessens you would have a very healthy and diverse portfolio.
Bottom line
When volatility is high, there is fear in the market and you could panic and make more mistakes. However if you cannot wait till the high volatility becomes milder, you should exercise caution.
You could seize the opportunity to trade the VIX by buying ETFs that track the VIX. Don’t forget to manage your risk using stop loss orders and GSLOs, calculate your risk to reward ratio and avoid excessive leverage.
