Charts 101: How to Use Volatility to Your Advantage
Uncertainty, volatility, bear market are all words we hear in these volatile times. But we should try to dissociate ourselves from the fear of these words and instead focus on how we can put these characteristics in our favor.
As traders, we need movement in the markets. But when there is an increase in volatility it can be frightening for some people, especially newcomers. So, what is volatility and how can you put it to use?
Basically, if the price of a stock or financial instrument moves up and down rapidly and the moves are quite large in a range then we can say the market is volatile. There are times when a market moves in narrow ranges and at other times quite large ranges which can create uncertainty for market participants.
In Chart 1 we can see that during the year 2008 between the months of July until August, the FTSE-100 Index traded between 5,071 and 5,649 points. We can see that the price bars which represent each trading day were narrow. This means that the daily range between the High and the Low appear to be similar and smaller in size. However from August until October 2008 we can observe that the price bars became greater in size and the market in essence became more volatile.
The lesson here is that if we were trading on the right side of the trend, which in this case had been to the downside, we would have had large moves in our favor. In this example the FTSE had been trading lower and we found that from August through to October the index dropped sharply lower and the red arrows indicate larger than average days mostly to the downside.
This is great news if one were short on the market. But if on the other hand a trader had been on the opposite side then losses would have quickly deteriorated their account. Therefore it is important to pay attention to volatility as well as risk management and not just market direction which most newcomers get fixated on.
But another factor to consider is how to trade in a low volatility environment. Typically a market will move in three phases: Up, Down and Sideways.
You may find that not always will a market be volatile. Sometimes a market can move steadily in the direction of least resistance. Let’s take a look at the February 2009 Gold contract in Chart 2.
We can see that from mid November 2008 Gold started to move higher from a low of $699 and after an initial thrust it has worked its way to the upside into February 2009.
There were two occasions in December and January where Gold dipped lower but did not form new lows. This type of pattern is quite common and typically where traders can become nervous and take their profits too early. Patience is a key element in trading and here one should be patient and allow the move to work itself out.
Stops could have been placed at the low points and moved higher as the trend continued higher. This would have allowed one to manage the trade appropriately without being stopped out pre-maturely.
Clearly the move higher had taken out previous highs and formed higher lows. This is a type of move that a trader would look for in a bull market.
Therefore we can now say that as long as we have figured out the path of least resistance and if a market becomes volatile then it is probable that the volatility could work in our favour.
Of course there are occasions when things can go horribly wrong. We can be in the right move in the right direction and a news or announcement could affect the market and turn the direction around in a split second. At times like this we can only look to manage the trade accordingly. Hence it is advisable to use protective stops at all times.
If a market looks too choppy or there is no clear direction of trend then either the market could be going through consolidation or uncertainty or it could indeed be just a difficult market to trade altogether.
What would be the best decision to make here? Probably to just stay out or wait until the market shows better characteristics of a smooth trend formation. Many traders feel that they have to trade a particular market or be in the market at all times. This is a common mistake and one that should not be taken lightly.
Trends do take time to develop and trying to pick tops and bottoms can cost a fortune. It would be better to wait for the trend to develop and try to capture the middle part of the overall move.
If at any time you feel that the price is not behaving the way it should be then it could be an early warning signal that something is wrong and maybe time to get out. Or if a market starts to become volatile and uncertain in the direction then this also could be cause for concern. At times like this sitting out of the market whilst it becomes more stable is a wise move.
Once the uncertainty of the move settles down and the price bars become narrow then an opportunity to jump on board may be around the corner.
As a trader one should always be alert and conscious of what the market is doing, and what type of characteristics are on display. Reading charts can be an art, a science and a skill that will take time to master.
Have a great trading week.
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