Market volatility can represent an opportunity for outsized gains or an opportunity for devastating losses. Firstly, volatility contains countless other factors embedded within and should be recognized as a meaningful indicator. Whether you ultimately decide to add or reduce market exposure, you should never expect an extremely volatile market to follow the same rules as a “normal” market. Below are some critical strategies for successfully navigating volatile markets.
Flexibility is everything
Because volatility inherently implies a lack of predictability, traders must be highly flexible in their analysis and positioning. Rigid models which predict linear trends are likely to break in these scenarios. For example, in the peak of volatility during March of 2020, many markets experienced massive swings in opposite directions on an hourly, daily, and weekly basis. Although there was technically a bottom and a recovery, short-term traders who were flexible and unattached from a single trend would have performed much better than those trying to predict an absolute outcome (in general).
The changing rules of a volatile market lead to so many abnormal events and conditions that perfect prediction is utterly impossible. For example, many securities became short-selling-restricted during the peak volatility in March, 2020. This means that those securities could only be sold-short after an uptick in price. Additionally, The Federal Reserve provided liquidity for Treasury Department special purpose vehicles to purchase non government- guaranteed securities. As always, traders don’t need to see everything coming, they just need to find an edge and press it. Accordingly, traders who remained flexible through all these unseen events were likely to find a dynamic which they could exploit effectively. Traders who didn’t expect the unexpected were in for a rude awakening and massive losses.
How liquid is the market/security you’re trading?
Obviously, many traders evaluate liquidity and money flows when considering positions, however, this becomes even more important during periods of high volatility. This is because investors who normally participate in different markets are often flushed out of those markets in a scramble for cash. Leveraged investors in particular are likely to flee volatile markets because they need to repay lenders. Concurrently, riskier assets lose liquidity as many investors reallocate their capital to safer assets (i.e U.S. Treasury Bonds) in an effort to abstain from the market volatility. If you are trading in securities with materially diminished liquidity, volatility will increase further, and a self-reinforcing cycle can occur; eventually, exchanges will halt trading on entire markets or individual securities if this cycle becomes too potent.
Once you understand the relationship between volatility and liquidity, how do you plan your trades around that relationship? First, you can attempt to find more liquid securities (primarily indexes or derivatives on underlying indexes) and trade those to avoid getting caught in low-liquidity pricing. Alternatively, you can attempt to profit from indirectly betting on liquidity. One way to do this is to short the securities you think will continue to lose liquidity and take long positions in the securities you think will gain liquidity. This strategy is based on the concept that liquidity will be drained from buyers more than sellers and therefore cause prices to fall when reduced. It is worth noting that in some cases liquidity can be lost on the supply side; this would occur when a small number of sellers are unwilling to sell a security at the given market price (pushing the price radically higher). Another way to bet on liquidity is through the expectation of mean-reversion. If you think the security price is directly correlated to liquidity and you think that liquidity will revert to the mean, you can bet on the security price reverting to the mean in relation to liquidity. For example, if you believe the liquidity and price of a security are perfectly positively correlated (correlation=1), and liquidity is 50% lower than the mean, you can take a long position with the expectation that liquidity will revert to the mean and the security price will follow it.
No matter how smart you are, experiencing volatile markets and reading about them are two very different things. The commonly discussed emotional component of trading is severely exacerbated under these conditions. New traders often panic and lose sight of their process while experienced traders (sometimes) keep a level head and find opportunities. Considering this, the first time you go through extreme market volatility you may want to consider keeping very tight stop losses on every trade or even simply staying in cash until the volatility subsides. Once you have already lived through one of these events and know what to expect, you should become more aggressive and trust your instincts to find the high-reward opportunities which come with volatility. It is important to note, however, that every market period is different and expecting the exact same thing to happen each time is very unlikely to be effective. Instead, the value of experience comes in the ability to remain rational and objective throughout the frenzy.
How do you manage risk in volatile markets?
Given the countless outcomes that can occur over extremely short-time periods, it is more important than ever that risk management be designed around the worst-case scenario. That is, any model which says XYZ can’t happen is inapplicable to highly volatile markets (and arguably inapplicable in general). You should diversify your trades and hedge when appropriate as always, however, at a certain point you simply must accept the potential for larger losses. The key is not to get discouraged by one bad trade and continue diligently pursuing opportunities even after the market goes against you. Also, unless you are extremely proficient at trading, it is generally better to avoid using leverage during volatile markets as margin calls can compound the losses you incur when a trade goes against you.
Surviving and thriving through extremely volatile markets
In summary, market volatility must be met with flexibility, liquidity analysis, experience, and diligent risk management. Many investors cannot handle the fear and pressure which accompanies volatility and become victims of it rather than benefactors. To ensure this doesn’t happen to you, try evaluating your understanding and experience with respect to each of these factors to decide if you are prepared to trade in extremely volatility settings. Although you can’t predict exactly what will happen during the next period of extreme volatility, you can set yourself up to be ready for whatever does happen.