How to trade in volatile markets
Volatile markets often scare inexperienced investors who are then spooked into withdrawing from the market altogether until things seem more stable… What you should realize is that volatility is inevitable in any financial market in the short-term and it can be difficult to time your investments accurately. As we have said, one solution is to withdraw from the market altogether to concentrate entirely on the long-term and ignore the short-term completely. Apart from ignoring profitable trading opportunities in the short-term, even long-term investors should try and learn the techniques of trading in volatile markets as a safeguard.
Volatility can be defined as the tendency of a market or a stock to move up and down sharply in price and it is measured by a statistical measure known as a standard deviation. Standard deviation indicates the range of movement that might be expected. For instance, the standard deviation of the S&P 500 index is about 15% whereas the standard deviation of a certificate of deposit is zero because there is no change in the return regardless of the condition of the market. Volatile markets typically see rapid price fluctuations as well as heavy trading volumes. They are often caused by a mismatch between supply and demand. Many people believe that volatility is created by emotions and investor sentiment. Whatever the underlying cause, volatility is a fact of life and investors must learn to deal with it.
One way of dealing with volatility as to construct a long-term portfolio which you will hold regardless of the market gyrations. This is an extremely difficult solution particularly when you watch the value of your portfolio plummet sharply. One of the most common misconceptions about the buy and hold strategy is that you must hang onto the stock for years without touching it in any way. Long-term investing still requires a lot of research and an understanding of the fundamentals of the company. It is true that short-term fluctuations are unlikely to affect corporate fundamentals. However, if you are convinced that the company is a good long-term investment, you should take advantage of declines in the price to increase your investment. This is the strategy called averaging down which means that while average cost comes down, your potential profit increases.
You should bear in mind that, in many volatile markets, market intermediaries will often follow procedures to decrease their own risk first and foremost. For instance, a market-maker may stop executing orders automatically and instead process them manually so that they are in complete charge of the situation. Here are some of the implications of these moves:
- There may be delays in executing your order because of the large volumes to be handled and you may finally get execution at a price that you do not like.
- The large volumes can hinder access to your online trading broker because of the limitations of the system in handling high volumes. Make sure that you have alternate ways to contact your broker such as the telephone
- You can expect to see significant discrepancies between the prices on your screen and the prices at which your trade is actually executed. Even real-time quotes may not be able to keep up and delayed quotes are completely useless