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Trading Education Posted by Team Topstep September 20, 2021

Are You Ready For A Volatility Spike?

Roller Coaster

While in the United States, the unofficial Summer season concluded with the Labor Day Holiday, the season technically ends in the Northern Hemisphere with the fall equinox. With the change of seasons, there could also be a change in market behavior. Today’s article will examine the historical rise in volatility during the autumn months. 

It can be challenging to trade during the summertime, as many markets often slow down and grind in tighter ranges. Not only is the weather ideal for getting away from the desk and enjoying the outdoors, but the uncertainties of a new year have often been resolved, and hardly anyone is focused on what’s going to happen at the year’s end. Therefore, summer, the midpoint of the year, often sees more stable price action. Combined with vacations and less institutional activity, the result can be a low-volume market that becomes less attractive. 

However, once autumn rolls into view, the world of finance experiences many psychological changes. First, with the summer over in the Northern Hemisphere, more attention is naturally placed on the markets. Furthermore, managers begin to assess performance versus expectations and begin to align and balance positions for the remainder of the year. This renewed interest in the markets often leads to an increase in volume and volatility. 

Don’t Discount Seasonalities

Sure, it’s hardly a rule of thumb, meaning that one cannot automatically anticipate an extreme uptick in volume just because the calendar turns. However, if we use the past to guide us, we should at least prepare for what could happen. Traders frequently depend on previous behavior; this is why we use charts, realizing that we can learn something from prior happenings. 

Volatility 20 Year Seasonal Chart

The CBOE’s Volatility Index is just one way of measuring volatility within a particular market, the S&P 500 index. For example, the chart above shows that the summertime is the point of lowest volatility over 20 years. However, historically, a spike occurs in the autumn, and levels remain elevated through the end of the year.

Furthermore, when U.S. equities are experiencing volatility, most often, so are other global stock markets. When stock markets are volatile, the same is true for other products, including government-issued bonds and currencies. When currencies are volatile, that affects commodities like gold and crude, which each have their own set of fundamentals that also often lead to higher volatility in the autumn. 

Volatility: Friend or Foe?

Volatility is often seen as the “big bad wolf” of the markets that people should fear, especially according to the media, which drives up ratings by manufacturing dramatic scenarios. The fact is that volatility should be approached with a balanced mindset.

Low volatility may be good for investors, but it can be frustrating for traders since these environments often create minimal opportunities and limited targets. Meanwhile, extreme volatility can be like a casino, leading to large winnings as well as significant losses. Thus, while we must learn to navigate volatility extremes, still, the healthiest place is when volatility lands somewhere in the middle— elevated enough to create ample opportunities but not extreme enough to generate erratic and unexplainable price action. 

Having established the opportunities that come with elevated volatility, the remainder of this article will examine positive and negative ways to respond to the rising volatility expected this fall. 

The 5 Best Ways to Adapt to Volatility

  1. Predefine Your Risk and Reward

Having a plan is not rocket science; it’s good preparation. One of the best ways to prepare is by developing a responsible reward-to-risk plan for such an environment. If you are going to trade in higher volatility, it doesn’t make sense to do so in the same way you would in times of lower volatility. My suggestion is to increase your return on risk. This is not only possible given the more significant price action, but reasonable from a risk management point of view since it makes trading in riskier environments more theoretically tolerable. 

  1. Let Winners Run

This is a huge difference-maker between an average trader and a great one. A key ingredient is to be patient with your winners; give them a lot of room to run. In volatile times, you can potentially catch a big trend that lasts not only minutes, but hours, and possibly days. Sure, if you have multiple contracts or lots, then you can scale out along the way; but leave something on the table to have a chance to achieve remarkable targets.

  1. Add To Your Winners

This rule goes hand in glove with the previous one, and it requires planning and forethought. However, if you catch a trend that’s going to ride, you can responsibly add to a winning trade while theoretically taking on no greater risk as long as you move your stop loss accordingly. This is a secret as to how big money is made. I know a trader who is only profitable on about 10% of his trades, yet, he runs a highly profitable desk. His secret is that when he catches a trend, he compounds winners. The antithesis of this, to add to losers, is of course not recommended, most especially in high volatility periods. 

  1. Stick To Your Plan

Volatility has a way of throwing markets off. In turn, traders end up reacting in ways that are not beneficial. One of the worst things a trader can do is abandon a well-informed plan and impulsively engage the markets. It’s no secret that high volatility often coincides with blowing up account balances. So the first mistake many traders make when suffering enormous drawdowns is compromising their plan.

  1. Become Self-Aware

The final step to successfully trading volatility is to know yourself. Sun Tzu says that those “who know their enemy and themselves need not fear the outcome of a hundred battles.” This step is self-analysis. You should be assessing yourself in all market climates, but it becomes all the more pertinent during times of fast-paced market action. 

The key is psychological—detecting the nuances of your reactions to your markets and your decisions. Sometimes, your responses may be physical; other times, they are mental or emotional. If any of these factors are coming into play when you trade, you should take careful inventory of how your trading affects you. For example, when your body or being is disturbed, presumably by risk or stress, you are more likely to make mistakes. 

The 3 Biggest Mistakes Traders Make in Volatility

  1. Removing Your Stop

Okay, I get it; trading in volatility with a stop loss is hard. Unfortunately, too many of us have been the victim of getting stopped out in a fast-paced market, only to see a losing trade turn out to have been a theoretical winner in a matter of seconds. However, I still believe that removing your stop is dangerous. The point is, without a serious stop order, any of us become tempted to negotiate with our risk parameters. The problem is that markets are highly volatile and are moving much faster than our thinking, so we end up becoming responsive rather than pre-emptive. By the time we take a stop, we have usually compromised our risk threshold to an uncomfortable degree.

  1. Overtrading

This one presents a serious problem in highly volatile markets. In one moment, the technical picture on a short-term chart can change completely from an ideal bullish setup to a perfect bearish pattern. Unfortunately, what often happens is we become hungry for action, and casino habits begin to take over and lead us to impulsive entries, and we think we will eventually score large. Often, the result is that we will get eaten up by fees and commissions and risk greater vulnerability by compromising our standards. It’s no secret that the perfect storm for blowing up an account balance is high volatility combined with overtrading. When we lose discipline, nothing good ever happens. 

  1. Firm Bias

Science demonstrates that as neutral as we attempt to be, the reality is that we are all biased. At times, trading bias can be a great ally. However, when it fails us, it is very often in high volatility environments when market direction turns on a dime. Still, traders stick too long to their original bias and find themselves trading against the grain of the market. This is another formula for blowing up an account. 

Wrapping Up

In conclusion, no one can forecast what will happen in your preferred markets over the course of the remaining year. However, regardless of what happens, you can be prepared. These are just a few of the many pertinent strategies that traders must consider when trading markets with rising volatility. I’m sure you have additional words of advice and perhaps even some ideas regarding markets that are poised to become volatile in the upcoming weeks, so feel free to reach out and share them with us!