Profit from volatility
Choppy markets create their own set of risks and opportunities for traders
Volatile markets create new opportunities as traders look to take advantage of heightened price movements, but they also introduce additional risks. A stop loss remains a trusty tool to protect traders against extreme losses, but in times of high volatility a tight stop may actually work against you: traders could find themselves kicked out of what transpires to be a good call because of initial price fluctuations.
Today’s market conditions mean participants have to broaden their approach to risk management in order to protect not just their downside, but also their upside. ‘Volatility has been a feature of things this year,’ says Matt Basi, head of UK sales trading at CMC Markets. ‘The US debt situation resulted in a lot of intraday volatility, and spreadbetters have been keen to try and benefit from that. But at the same time, they have sought to protect themselves from adverse movements.’
As the uncertain geopolitical situation has sent jitters through the markets, a commonly used strategy among traders has been pairs trading, whereby investors go long one asset and simultaneously short another one.
‘What we have seen clients do is staying long on the stocks they think are going to outperform the market, but at the same time taking short positions in the major indices to try and hedge out the general market risk,’ says Basi. So for example, you could bet that Barclays (BARC) will outperform the market, meaning a profit will be made as long as it does better than the index, regardless of overall market direction. ‘To manage your market risk sensibly, try to take positions that are not completely directional, and take a view on outperformance and not just explicit performance,’ adds Basi.
The stop loss dilemma
While traders continue to use stop losses very actively to protect themselves in case the markets move aggressively against them, there is also plenty of nervousness about having stops that are too narrow as prices jump around. Hence the dilemma: you may have a strong opinion about where an instrument may go, but the tight stop loss which will protect the downside could kick you out of a good trade on some bad initial volatility.
This is in part why risk management in the current volatile conditions goes far beyond a simple stop loss, where a 10% price dip triggers an immediate sale to prevent further suffering. For serious traders, stop losses are just one factor in risk management, says David White, financial trader at Spreadex. ‘Using a stop loss is fine, but understanding risk management begins with understanding the thing you are dealing in the context of the broader market.’
In fact, White would not necessarily recommend using stop losses at all in turbulent markets. This will of course depend on which strategy a trader wants to employ: ‘If you are looking to participate in momentum, you would want your stops to be tight, but not too tight. If however you are looking at a longer value play, using a stop is probably not a good idea at all,’ he explains. This is because a value play can be disliked by the market in the near term, meaning a position can take a while to start moving in the anticipated direction, and it can slip further in the wrong direction before this happens. For traders reluctant to go without a stop loss at all, a looser stop could be a compromise: ‘But if you work a tight stop, you can get stopped out and never see what you were hoping for,’ reminds White.
Walk, don’t run
Spreadbetting is becoming an increasingly popular tool for exploiting volatility and downward movements. Beginners are however warned not to run before they can walk: learning about the market takes time, and so does implementing complex pairs trading. Doing too much too soon is a common mistake among beginners, says White, but so is going in with a single trade.
Diversification ensures some protection from market risk, meaning traders should pick a range of instruments not particularly correlated with each other. ‘The problems occur when people start to use borrowed money to trade some small oil and gas stock which then moves very frantically,’ explains the Spreadex man.
Over recent months, traders have taken on bigger risks in the hope of cashing in as news events move the markets, says Shai Heffetz, head of financial spreadbetting at InterTrader Direct: ‘Traders see the market moving in all directions, and people have a tendency to see patterns where they may not exist.’ Heffetz reports increasing volumes of arbitrage trading, as well as lots of pairs trading where participants are looking at correlations between different currencies and indices.
He also agrees that stop losses should not be the final port of call for handling risk: ‘With correlation trading you usually go short one thing and long another, so using stop losses is not something you necessarily would do because you do not have pure directional risks.’ Having said that, there is no guarantee that indices or currencies that traditionally follow hand in hand will continue to do so. ‘During 2010-11, you could have traded euro, dollar and the Dow together and consistently made money. Many traders were riding that correlation, but one day that correlation broke.’
Ultimately, most traders will use a mixture of stop losses and long-short hedging strategies to manage risk in volatile markets. Even so, there still remains a significant potential for losses, cautions CMC’s Basi, who recommends traders take out a series of pairs spread across various sectors and markets. ‘Say you like Apple (AAPL:NDQ) in the States, Barclays in the UK, and [Banco] Santander (SAN:MC) in Spain. Were you to go long on these, and short on the S&P, the FTSE, and the IBEX, it is unlikely you would see all the major indices rise at the same time as all the stocks falling.’
While we are seeing price fluctuations and overall market nervousness due to geopolitical uncertainty, Basi points out the markets are not actually trading too dissimilarly to what they have been doing over the past three years. ‘The issue right now is more that of perceived risk. The sentiment among investors is certainly that the potential for a very sharp correction is as strong as ever.’
White agrees that much of the volatility right now is not fundamental but psychological, pointing to the relative stability of the VIX index, the measure of implied volatility of S&P 500 index options. ‘We have had a stable period of return for risk assets for quite some time now. But that is not to say there are no risks out there that could really see the tables turned.’ White points to the resolution of the US debt ceiling crisis earlier this month: ‘If a deal had not been brokered you would have really seen some serious volatility.’
While most analysts will agree the likelihood of the US defaulting on its debts is extremely small, the troubles in the eurozone show that extreme events are certainly not unthinkable right now. Brutal as it may sound, a spreadbetter could even stand to benefit from such an event, as IG Index founder Stuart Wheeler discovered when the 9/11 attacks happened while he had an open bet that the Dow Jones would fall. Writing in The Spectator earlier this year, Wheeler admits he made £1.3 million on the freak event, concluding: ‘You can make huge sums by spreadbetting, but the risks are formidable.’ While stop losses are not the end of the story in times of volatility, they do remain the hard limit against the unexpected in a way no pairs trading strategy can do on its own.
Sharas Magazine 31 October 2013