Your Survival Guide to Volatile Markets #57

Market Meditations | December 22, 2020

In today’s education letter, we explore market volatility and the different options available for trading it.

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Your Survival Guide to Volatile Markets 

Market Meditators, we have recently seen extremely volatile markets. We saw Bitcoin flirt with ATH about one month ago, only to see a correction which then marched right back up to an ATH. In today’s education letter, we explore market volatility and the different options available for trading it.

Market volatility can make even the best of traders question their trading strategies. This is especially true of new traders. A sudden reversal will see them pull out of the market altogether and wait on the sidelines until it seems safe to come back in.

It is important to realise that market volatility is inevitable. Even when the market seems still, it is not. To draw on an analogy we use frequently in the letter, imagine a constant battle between the bulls and the bears. A tug of war that takes only the slightest push to tip the scale and cause one side to come toppling down. In practise, this translates to short term volatility. 

In this context, volatility is a statistical measure of the tendency of a coin to rise or fall sharply within a short period of time. We can measure it through the standard deviation of the returns. Volatile markets are usually characterised by wide price fluctuations and heavy trading. 

There is no clear consensus on what causes volatility. Some blame day traders, others headlines or a recommendation from a well-known trader. Many blame psychological forces. This behavioural approach says that volatility results from a collective change of mind. Sometimes referred to as herd mentality.

Looking back on chart action, hindsight trading, may make it seem straightforward but in reality, trying to time the market is extremely difficult. So if we take the assumption that market volatility is inevitable and difficult to predict, traders are left with a few options. 

Option 1: Do not enter a volatile market 

Before you make a trading decision, you should understand the type of market you are entering. The first question you should ask yourself is if you have a proven trading system, without this you are gambling. Next consider the psychological strain, are you are willing to see the market take a sharp turn and watch your profit and loss update accordingly? If you are not prepared to withstand such volatility, appreciate the opportunity cost here and invest or trade in something else. There is no shortage of opportunities in this space. Pick them wisely. 

Option 2: Maintain a long term horizon 

It may be in your best financial and emotional interest to ignore short term fluctuations altogether. This means keeping your position and not paying attention to short term fluctuations. In other words, a buy and hold strategy. For instance, you were long bitcoin because you had a fundamental viewpoint. Your fundamental viewpoint was that the amount of monetary stimulus to facilitate the spread of the coronavirus pandemic will have inflationary implications to the extent that traditional asset classes will not yield the type of returns that cryptocurrency will. So, when the correction happened, you would have essentially ignored it and held your position. Anyone who actually did that will know that it is easier said than done. Most people can’t watch their portfolio take a hit in a bear market. 

If you take this option, make sure you have the emotional capacity for a buy and hold strategy and that you still adhere to an overarching risk management strategy. Here’s a good place to get started on risk management. If you can do this, a nice way to monitor or even build on a position like this is dollar cost averaging

Option 3: Trade the volatility and respect your levels 

You may decide to trade the volatility because you are not phased by the short term fluctuations and in fact you think you can profit off of them. Very good. But know your risks. First of all, you may experience delays. Volatile markets come with high volumes of trading which may cause delays in execution. So, you might not get the price quoted at the time your order was executed. You may also have difficulty executing your trades because of the limitations of an online system’s capacity (one of the main reasons I use Phemex is their extremely fast matching engine). Prices may gap significantly, be sure you are prepared for this. 

If you do understand the risks, it is essential to proceed with a proven trading system. Once you have established these and the associated risks, you are set to trade market volatility. 

We have experienced volatility so far and we will experience it again. All traders should be aware of the risks and how they would react to short term volatility. There are different options available and traders should be honest with themselves and know when it is time to dive in and when it is time to wait. 

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