What Not to Do in Volatile Markets

10/21/2011 9:40 am EST

Focus: STRATEGIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Certain misconceptions about bear markets and volatility can cost traders dearly, says John Jagerson, who explains some common pitfalls to avoid.

Volatile markets are great for traders because there’s lots of movement, but you may need to adjust your trading strategies a bit to be safe during those times. 

Our guest today is John Jagerson, so John, how do I need to adjust my trading strategy in a really volatile market?

Well, there’s a common misconception out there that all you really need is a trend and that bear trends are the equivalent of bull trends. In some markets that may be true, but in most markets, it’s not, and the difference really is the level of volatility. 

In a bull trend, the volatility of daily price moves are relatively small, so covering your position with a stop loss or something like that is going to be pretty effective risk control. 

In a bear market, although the trend exists, it moves much faster and can result in much wider price swings on a day-to-day basis. 

So traders evaluating their positions in a market like that can’t think about them in the same way that they would in a bull market. They have to accommodate those wider price swings and the fact that those trends are going to be shorter because they move so much faster…it’s shorter in time frame I mean.

Alright, so is it as simple as reducing my size in half and then increasing my stop to make sure I don’t get stopped out with those whippy moves?

Well, that may not be a bad approach, but I think that maintaining consistent position size in a bull or bear market is still going to be something that has value and probably should be pursued by most traders. But in taking risk in a bearish market or a volatile market, you may have to open yourself up to a little bit additional or wider risk tolerances, so if you’re using stop losses, making those a lot wider. 

Now that should be offset by the fact that big price swings result in some bigger profits, or even changing your risk control methodology completely. So while you may use stop losses that are relatively inexpensive in a quiet market, you might buy protective puts: expensive, but very effective in a really volatile market. 

It can be a bit spooky in a volatile market because things are moving so quickly. At what point do I just say, "You know, I’m going to step out and sit on the sidelines for a while?"

Well, anytime. That gets to emotions as a trader. I think it’s perfectly acceptable for traders to take a break from the market if it’s interfering with how they feel about their work. 

That’s a warning sign that you’re about to make some bad decisions, so if you feel stressed, it doesn’t matter what the market’s like, you probably should step out. But if you’re not so stressed, you want to still participate in the market but you are concerned with volatility, trade less frequently; move a little additional money into cash or more conservative investments. Keep your position sizes the same, but perhaps take fewer of them. 

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