Markets in chaos are causing mayhem for less seasoned traders. While the more experienced can cope more easily with multiple losses in a row, knowing a big win will occur sooner or later, those with less practice struggle with emotional upheaval – a major reason why markets over-react.

You make a trade, buying the Australian dollar against the greenback, for example. The currency moves up at first, but quickly nosedives, taking out your stop-loss. There were no profits to protect, so this is a losing trade. You’re now out of the market as the local currency resumes its upward trend, and you climb on board again, only to be stopped out again.

Expecting further falls, you short the Australian dollar only to have another quick reversal take out your stop-loss again. After this has happened multiple times, the temptation is to give up in despair, or to trade a larger position size to make sure of a big win on the next trade, or to move your stop-loss level at the last minute to keep from having another losing trade.

Yielding to any of those temptations would be to risk throwing your trading strategy away and trading on gut instinct, the worst possible guide when emotions are running hot. The disturbance to rational thinking caused by the pain of several losing trades is acute, and lack of discipline in sticking to trading and risk management rules can be disastrous.

Which is why many traders are on the sidelines at times like these, when the Australian dollar can move by US 6 cents in a week, and the US share market index, the Dow Jones Industrial Average, has seen daily trading ranges of 400 points and more – a multiple of its usual daily swing.

As brokers man the phones to call for margins – more cash to cover positions that are in loss – clients have been calling in, anxiously asking how to cope with such difficult market conditions. (For some suggestions, see Tips for Trading the Turmoil, below).

Trader educators suspect most traders would have eased off their activity a little recently. That tends to be the case when markets get wild, but some get drawn into the fray. There are increased opportunities but there is also increased risk.

The more advanced traders are trying strategies they would not have attempted in the past, trying to capture big gains while minimising risk. Although many have tried to become more sophisticated in their approach, not all have succeeded.

Some have been willing to look at trading new instruments, many venturing outside the familiar stock market for the first time and looking at foreign exchange and commodities and the possibility of making gains from shorter time frames.

Others don’t mind taking on board added risk, but they will have a hedge in place using options, CFDs or a combination. This might involve buying a stock and buying a put option to reduce downside risk. Or it could involve buying several different shares and adding a partial hedge using index CFDs or index warrants.

Michael McCarthy, chief market strategist at CMC Markets, says option traders have been particularly busy in recent weeks. “People are buying portfolio insurance or selling puts and calls [options] to take advantage of high volatility.”

Although selling (writing) options is an advanced strategy, there are some basic option trades that reduce risk, such as buying put options to hedge against a market fall.

Such markets as we have seen recently encourage traders to think outside the square. Some are looking for high beta stocks. If the sharemarket moves as it did in mid-August] up aggressively from an S&P/ASX 200 index level of 3800, those stocks will move at least in line with the market, if not further.

Beta is a statistical measure of how far a stock has moved relative to the market – a beta higher than 1.0 suggests the stock will outperform in a rally.

According to a prominent trader educator “Traders are looking for particular stocks; it’s a stock-picker’s market. Rather than just buy BHP, they are trying to find stocks where there is a distinct advantage, like a takeover play. Austar is an example; the regulator said no [to Foxtel’s bid] but some traders remain confident the deal will go through in some form. It has traded below the previous bid price and if the bid goes through they are getting a discount.”

Other potential takeover stocks traders have an eye on at present are Macarthur Coal, Fosters and Extract Resources. In current conditions such opportunities should be taken in the context of having some protection. Taking long equity positions with index protection you removes most of the sting from market risk. (Market risk is the risk that a fast-moving market will take all or most stocks along with it, irrespective of fundamentals.)

Educators reiterate the need for a cautious approach in what has been a difficult period. They suggest staying on the sidelines and waiting for more conducive conditions if you’re not prepared to take added risk.

Chris Weston, analyst at CFD provider IG markets, says “This is a time when leverage can blow your account up. Not just leverage from the products but from the market. Markets usually go up stairs and down the elevator, but they’ve been riding both ways. I wouldn’t say this is a new norm but traders should be getting used to more volatility.

“Take your size right down; don’t try to be a hero,” is the first advice Weston offers. He adds: “You have to trade with stops. Leaving positions overnight can be risky.”

Nevertheless, he points to the difficulty of using stop-loss orders when the Dow drops 200 points and then rallies 400. “You have to use money and risk management but if you do get a break-out [a sustained trend] you can do well.

He says traders do best when they look “outside the box. Look at the thematic and look at the different assets. This is a headline driven market. For a while it was driven by real fear then people were saying it’s overdone and now we’re having a short covering rally. I believe we can go lower [in the equities markets] because people are starting to talk themselves into another recession even though the chance of full-blown double-dip recession in the US is low.”

But in this environment currencies have come to the fore as proxies for risk and the search for a safe haven has put gold on trader’s minds. “The two beacons, the front running indicators, are the Aussie yen and the gold price,” Weston says. “The fact that we haven’t seen money flowing back into equities from gold suggests the underlying fear hasn’t gone away.”

One of Weston’s trades at present is a pairs trade between the Australian and US sharemarket indices. This involves buying Australian S&P ASX 200 derivatives and selling a roughly equivalent value of US index derivatives on the basis that the Australian market, the underperformer so far this year, will outdo its American counterpart in the foreseeable future.

“If we see global markets coming off the Aussie dollar will fall which is good for industrial stocks. We are looking for net outperformance,” he says. The US index he favours in such a trade is the Nasdaq index of technical stocks, which have moved up strongly but look susceptible to any weakness.”

Tips for Trading the Turmoil

Here are some of the measures the best traders take to cope with high volatility in the markets:

1. Widen stop-loss orders. When placing stop-loss orders, leave more room for movement as markets make wider swings. Use daily range as a guide, but be wary of sudden increases in range. “Average true range in the Dow recently blew out to some 300 points but the market was making bigger swings than that in a day,” Weston of IG Markets warns.

2. Reduce position sizes. If you’re trading according to standard rules that say don’t risk more than 1 per cent of capital on any trade, then you set your stop-loss according to market conditions. The stop-loss distance from entry, multiplied by the number of units you buy or sell, must not be more than 1 per cent of total trading capital. As your stop widens, position size must decrease. “It’s a trader’s paradise. This volatility is what we’re after, but you have to put wider stops in which takes size down,” says Weston.

3. Trade over a shorter time frame. For those who have the time, this maximises opportunity by focussing on gaining from quite short-term moves, sometimes over a few minutes or hours. It does mean putting extra time in front of the screen.

4. Diversify from equities into foreign exchange, metals and other commodities.

5. Make use of indicators such as Bollinger bands, which are probability indicators plotted either side of a moving average. As the market becomes more volatile, the bands widen, and show when the price has moved beyond the level expected statistically. This signals a possible price reversal.

6. Consider an options or index hedge. If you’re buying stocks, you can hedge against market risk using index options and against specific risk using stock options.

7. Look at pairs trades, which are combined bought and sold positions designed to take advantage of one stock, sector, index or commodity that will outperform another.  This reduces potential reward, but in most cases also reduces risk.

8. Trade Volatility Index (VIX) futures if you think volatility is likely to change suddenly. Periods of high volatility are often followed by more subdued markets, and the VIX futures market in the US allows you to take a view on which way volatility will move without having to trade complex option positions.

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