Trading strategies – the basics of trading in volatile markets

Britain’s referendum on EU membership is creating increased volatility in financial markets. Assets affected by the decision – such as the pound and UK stocks – are the most susceptible to big swings in the days around the vote on June 23rd.

One-month implied volatility of cable (GBPUSD) has soared to its highest since the financial crisis, while the cost of insuring the euro against sharp swings versus the dollar is at its most since the height of the Eurozone crisis in 2011.

Stocks are also bearing the brunt of traders’ nerves – the CBOE Volatility Index, the so-called ‘fear gauge’, hit a four-month peak in June. The Euro Stoxx 50 volatility index has nearly doubled this month.

Whether it’s the EU referendum or the forthcoming US election, trading around major events can mean more opportunities as volatility peaks – but it can also mean added risk, making it all the more important for traders to develop a volatility trading strategy.

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Limit Orders

 

The simplest tactic for volatile markets is to make use of limit orders. Limit orders mean you can buy or sell into a market at a price decided by you, as long as the market moves in the direction to trigger the order. If it doesn’t move that way, the order is not filled. By using limit orders traders can establish enter a position only if the market comes to them. The idea is that this reduces the chances of entering a losing trade and enables the trader to only open a position once a trend is confirmed.

Stops and Trade Size

 

Some traders advocate reducing their position size rather than relying solely on stop-losses. As markets can oscillate rapidly a stop-loss could stop the trader out in the blink of an eye. Instead, by only trading amounts that the trader can afford to lose it’s possible to manage risk without reducing the upside potential. Stop losses are still important but the emphasis is on smaller trade sizes to allow greater flexibility.

Fading the Gap

 

Experienced traders can look to something called ‘fading the gap’ to make the most of heightened market volatility. Essentially this involves shorting the market after it gaps up (or going long if it gaps down), to play on short-term retracements and irrational exuberance.

Traders are looking for the gap to be filled – ie, the price begins heading back to where it was before the gap occurred, which for stocks is often a closing price. Once it starts to fill, it’s hard for the gap not to be filled as there is often virtually no support or resistance in place.

Options Straddle

 

In the options market, a straddle is when the trader holds a call and put call on the same security with the same expiry date and strike price. A straddle is a useful strategy if the trader believes the price will move a lot, but is not sure in which direction.

As long as there is dramatic movement in the price of the security, the rationale is that a straddle means traders can make money whether the price rises or falls. However, if there is only a small price movement, a straddle won’t work.



Added market volatility means increased opportunity but also more risk. To reflect this, ETX Capital may be increasing margin rates on certain markets.

Any information, analysis, opinion, commentary or research-based material on this page is for information purposes only and is not, in any circumstances, intended to be  an offer of, or solicitation for, a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. Any person acting on it does so entirely at their own risk and ETX Capital accepts no responsibility for any adverse trading decisions. You should seek independent advice if you do not understand the associated risks.