How Traders Can Take Advantage of Volatile Markets

To make money in the financial markets, there must be price movement. Fortunately, price movement is a constant in the markets. The key factor is how rapidly prices are moving. The speed or degree of change in prices is called volatility.

The good news is that as volatility increases, the potential to make more money quickly also increases. The bad news is that higher volatility also means higher risk. When volatility spikes, you have the opportunity to generate an above-average profit, but you also run the risk of losing a great deal of capital in a relatively short period of time.

With a disciplined approach, you can learn to manage volatility for your benefit—while minimizing risks. Here are four steps to consider to take advantage of volatile markets.

1. Define your objectives and bolster your defenses

Before embarking on a course to trade volatile markets, it's important to be mentally and tactically prepared to manage the risks involved. So the first step is to make sure that:

• You are comfortable trading when volatility is high.
• You recognize that there is the potential for significant loss of capital and are prepared for this risk.

Assuming you are "ready for action," the next prudent thing to do is to revisit the risk control measures you have as part of your trading plan.

Two important considerations are position size and stop-loss placement. During volatile markets—when day-to-day price swings are typically greater than normal—some traders place smaller trades (commit less capital per trade) and use a wider stop-loss than they would when markets are quiet. The goal is to avoid getting stopped out due to wider-than-normal intraday price fluctuations, while attempting to keep your overall risk exposure about the same. As always, traders should note that stop orders can be executed far away from the stop price if there is a big price gap or rapidly changing market conditions.

2. Focus on stocks trending with the market

One key opportunity in trading volatile markets is that trending stocks may actually see the rate of their trend increase. This means that looking for stocks that are already trending in the direction of the overall market may afford a trader the opportunity to generate profits more quickly than during normal, quieter markets, albeit with a potentially higher degree of risk, as mentioned earlier.

The key to this approach is to find a stock that has been trending higher (if the stock market is in an uptrend) but which has not yet accelerated the pace of its advance. A short seller trading in a volatile market should look for a stock that has been declining but which has not already experienced a collapse or "waterfall" decline. The goal is to get in before an acceleration in price, not after.

3. Watch for breakouts from consolidations

One common trading method used by many traders is "buying the breakout." With this approach, a trader monitors a stock that is trading within an identifiable support and resistance range. As long as the stock remains within that range, no action is taken. However, if the price breaks out to the upside, the trader will look to buy the stock immediately in hopes that the breakout signals the beginning of a new up-leg for the stock.

In quieter markets, a stock may breakout to the upside and lose its momentum, drifting sideways or eventually falling back below the breakout level. However, in a volatile market, where prices are moving rapidly, an upside breakout can be followed by an immediate and substantial run to higher prices. This type of potential is the primary reason to trade breakouts in a volatile market environment.

The catch is that in a volatile market, a reversal from a false breakout can come very quickly and the subsequent price decline may be more severe than in a quieter market. As a result, a trader who chooses to buy the breakout in a volatile market should seriously consider a stop loss-order to potentially limit their loss after the price falls a certain distance back below the breakout point (or some other acceptable percentage amount).

4. Consider shorter-term strategies

Another approach that traders use when markets are volatile is to adopt a shorter-term trading strategy. This typically involves attempting to take profits—or at least lock in profits—more quickly than normal. Consider the example of a trader who typically buys stocks as they break out above resistance. Typically, after entering a trade, this trader places a stop-loss X% below the entry price and then waits for a profit of at least Y% to accrue before activating a trailing stop—that is, a conditional order that uses a trailing amount, rather than a specifically stated stop price, to determine when to submit a market order. The trailing amount, designated in either points or percentages, then follows (or "trails") a stock's price as it moves up (for sell orders) or down (for buy orders). As the stock rises in price, the trailing stop will also rise, thus allowing you to potentially sell at a higher price.

But in more volatile markets, when profits can vanish and turn into losses in the blink of an eye, you might consider making the following adjustments to exit the trade more quickly:

• Set a specific percentage profit target.
• Sell part of a position at the first good profit-taking opportunity and hold the remaining position in hopes of generating additional profits.
• Use an overbought/oversold type indicator (RSI for example) and sell when it signals that the security is overbought.
• Activate a trailing stop sooner than normal and/or use a tighter trailing stop than normal.

Be prepared

Traders crave price movement as it offers them an opportunity to make bigger profits. But at times, price movement can accelerate beyond what they are used to. A driver traveling 100 miles per hour has the potential to reach his destination more quickly than one traveling at 60 miles per hour. However, the first driver must be prepared to deal with all the hazards that come with traveling at such a high rate of speed.

The same is true for traders. When market volatility reaches a certain level, things can start to move so quickly that closer attention and a change in tactics may be necessary. The key is to prepare in advance. The steps discussed in this article are no guarantee to keep you on course, but are worthwhile to consider if you think you're ready to take on volatile markets.