In trading, volatility can best be described as the fluctuation in the price of an asset over a particular period. High volatility occurs when an asset experiences large price changes within a very short time, while low volatility is when an asset experiences small price changes over a longer period.
There are several ways to quantify market volatility. However, the average true range (ATR) technical indicator is regarded as the best and the simplest method.
Some traders, like scalpers, prefer trading in highly volatile markets since they can accumulate several pips in a short period. However, periods of high volatility present inherent risks such as slippages, higher spreads, and negative balances. All these amounts to extra costs to a trader. In this article, we will discuss some of the best ways to mitigate these risks.
Trading With Smaller Lots
Lots are the size of the positions you take per trade. Trading smaller lots per trade mean that only a small percentage of your trading account is exposed to market volatility. Remember that in a volatile market, the price could either go your way or against you. If the market is against you, even if you are using leverage, the amount you stand to lose will not significantly impact your capital.
The logic behind using smaller lots in highly volatile markets is to prioritise capital preservation.
Using Stop and Limit Orders
In trading, stop and limit orders are pending orders, which are automatically executed only when an asset reaches a specified price. Buy stop and buy limit orders ensure that you go long at a specific price, while sell stop and sell limit orders ensure you short the market at precise price points.
In volatile markets, prices are prone to slippages resulting in a difference in the price at which your trade is executed compared to the one you requested. This means that market orders are inefficient during volatile periods, as they may result in avoidable costs.
You should set take profit and stop loss levels for each trade. Setting TP ensures that your trade is closed at a profitable level even in a swing market, while SL limits the downside you face. They automatically close out your trades at a specific price level.
Trading Less Volatile Instruments
The causes of volatility in the market can be narrowed down to either inflammatory news release or reduced liquidity. This means that, at any time, volatility tends to be localised to a few tradable assets since not every tradable asset can be illiquid at the same time or impacted by the same socio-economic development.
Mitigating the risks that you potentially face in a volatile market will depend on selectively trading the less volatile instruments. This means that you have must familiarise yourself with the scheduled new releases and geopolitical developments that may impact specific tradable assets. More so, you should monitor the volumes being traded for the instruments you are interested in. Most brokers provide this information.
Hedging Spot Trades with Options
Hedging is used to protect your portfolio against potential losses from volatile markets. Vanilla options are the simplest form of options trading strategies. Vanilla options allow you to buy or sell a specific asset at a pre-determined price at a future date – but you are not obligated to buy or sell.
Call options give you the right to buy a specified asset, while put options allow you to sell a specified asset at a specific price and date. Here’s a simplified example.
Say that you buy GBP/USD at 1.3788. But with the potential deadlock in the post-Brexit trade negotiations between the UK and the EU, you anticipate that the pear might turn bearish. Y choose to buy a put option to mitigate the potential risk. In this case, if the pair becomes bearish, you get a pay-out. However, if the pair continues on a bullish trend, you can keep your GBP/USD position open and choose to exercise your put option.
Note that not all brokers allow hedging.
Volatile markets tend to cause increased price unpredictability which often leads to a breakdown of technical analysis tools. This, however, shouldn’t prevent you from trading during volatile periods. With the strategies discussed above, you should comfortably mitigate the risks of trading in high volatility periods.