When asset prices are trading wildly, during, and immediately following adverse market conditions, you need to apply several different techniques and have a specific mindset to be successful. Volatile markets describe a scenario where investors are nervous which means that price action can be inconsistent and could force you out of a position very quickly. In addition to trading assets that have robust liquidity, you need to trade using wide stop-loss levels as well as potentially decrease your position size. Here are some great tips on how to invest in volatile markets.
COVID-19 came on the seen in early January, but not start to impact all the capital markets until late February. The Asian markets were the first of the capital markets to experience volatility due to the spread of the virus. While Asia was trading under pressure in mid-February, investors were flocking to the US markets were investors were experiencing relative calm. This did not last long and by late February the entire globe was feeling the impact of COVID-19.
During early March, the spread of the coronavirus created volatility around the globe. Implied volatility on many assets started to spike. Implied volatility is a measure of future volatile, and generates the inputs that are used by options traders to price the premiums used in options trading.
By late March, the benchmark volatility index, the VIX, surged to an all-time high of 85%. By late April, the VIX has been cut in half, falling to 40%. A VIX of 85% means that the price of the underlying asset, in this case, the S&P 500 index, will move approximately 5.3% per day. A VIX reading of 40% means that options traders expect the S&P 500 index to fluctuate 2.5% every day. This compares to the long-term average (200-days) of the VIX which is closer to 20%. In February the 200-day moving average was closer to 15%.
COVID-19 has changed the landscape for investors, generating volatility within the capital markets across all-assets. The volatility index for the EUR/USD which historically has traded near 4%, jumped to a high of 19% in late March and has settled in near 9.5%.
So How to You Navigate Extreme Volatility
With volatility at extreme levels, you need to use several different techniques to ensure that you make money. The first step is to adjust your position size. In theory, you should reduce your position size by a ratio that reflects the increased level of volatility. For example, the EUR/USD implied volatility is more than double the average volatility over the past 12-months which means that you should consider reducing your position size by half. The implied volatility on crude oil is nearly 7-times the level of the average over the past year which means you should consider adjusting your position size by 1/7. By reducing your position size by the increase in the theoretical future movements in the price of the asset you are trading you are likely to make the same amount of money you would have made in non-volatile conditions.
Dealing with Fear in Volatile Markets
For example, if your goal was to make 50-pips in EUR/USD, using your normal position size of $1,000, a VIX that has doubled has increased the chance that the EUR/USD will reach your goal or stop you out by 2-times. The issue is that extreme volatility will increase the whipsaw price action to a level that stops will be hit on both sides of the market possibly taking you out of your position sooner than normal.
The way you could handle this extreme volatility is to reduce the size of your position in half to $500 and increase the amount you are looking to make by 2-times to 100-pips. This will allow you to make the same amount of money but reduce the risk that you will not be able to hold on to your position during extreme volatility.
You also want to make sure that the assets that you trade during this period continue to experience robust liquidity. For example, the EUR/USD generally has a bid/offer spread of 1 or 2-pips. During the COVID-19 crisis, the bid-offer spread has remained stable. This has not been the case for all assets, and the ones that have seen liquidity suffer should be avoided.
The Bottom Line
The key takeaway is the volatile market conditions can change the way you trade. You should avoid assets where the liquidity is greatly reduced. You should also consider changing your risk management. You can reduce the size of your position size by a ratio that is inverse of the increase in volatility. So, if volatility doubles, you might consider reducing your position by half. You can then increase the percent gain you are looking to capture and also increase the stop loss to incorporate the reduced size of your position.