The Chicago Board Options Exchange Market Volatility Index (VIX) was designed to gauge the amount of fear among the investors. An increasing VIX number indicates a market where investors are in ‘fear’ mode.
In most cases, an increase in volatility leads to a market sell-off while a decrease in volatile leads to normalized situations. Many investors dislike periods of increased volatility while many traders like the increased volatility.
This is because with an increased volatility, they can easily enter and exit positions, making huge profits within minutes. But the opposite is also true; entering the wrong position could lose a lot of money.
That is why it is critical to understand how to analyze volatility and know the tools to best deal with this uncertainty and volatility in the market.
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Why volatility is good for traders
There are three main types of markets. First, there are volatile markets, where the rate of change tends to be faster. For example, if a stock opens at $10 then rises to $12 and closes at $9, it can be said to be highly volatile.
Second, a market be said to be stuck in a consolidation phase. This happens when a financial asset is stuck in a tight range and is not moving much. In most periods, traders hate it when a stock is moving in a consolidation phase.
Third, there is a period when an asset is trending. This happens when an asset is making a series of higher highs and higher lows. A trend can also be said when it is forming a series of lower lows and lower highs.
Traders love it when markets are trending or are in a volatile phase since it creates an opportunity for them to buy and sell assets.
VIX and the EURUSD
Seasoned investors and traders are certain of two things in the financial market: uncertainty and volatility. It is during these two extreme times that traders make most money. It is at these times too that most people lose a lot of cash.
Trading a normal market without the macroeconomic data would not be as interesting as it is today when market moving information is released on a daily basis.
Well.. the anticipation of what the data will bring leads to uncertainty and volatility. For instance, many analysts could expect the fed to raise interest rates in the next quarter (here are some strategies to predict a FED rate change).
Towards this period, the amount of volatility and uncertainty will be high because no one is certain enough whether the tightening will happen. This leads to increases in the VIX index.
Monitoring the VIX comparing it with other tools
As a day trader, you should make it a habit to having the VIX index always in your screen. It should be the first screen you look at any time before you start trading. Doing this will help you understand the market and also give you a forecast of what to expect.
You should compare the trend in the VIX with the price action of the major instruments, such as the index future contracts and the dollar index. By comparing the convergence-divergence relationships between the VIX and these instruments is an indicator of what the market will look like during the trading session.
By looking at the charts before a trading session, a number of things can be made:
- A rise in VIX, S&P 500, and the NASDAQ signifies a bearish trend which presents a good opportunity to short the market.
- An increase in the VIX, a fall in S&P 500 and NASDAQ index futures signals a bearish convergence.
- A failing VIX, a rising NASDAQ and a rising S&P indicates a bullish trend for the day.
Therefore, by having a look at the VIX and comparing it with the key indices and instruments, you will be at a good position to make good decisions during the trading day.
Don’t follow experts blindly
Ideally, on a daily basis, you will hear from the crème-de-la-crème of the financial industry. Analysts from Goldman Sachs, Morgan Stanley and City will be in the leading broadcasts (Bloomberg and CNBC) discussing the macro trends of the day.
As a trader, the best thing to do is to listen to what these guys are saying but make your own independent decisions. The fact is that these guys are always wrong!
For instance, only a very few analysts such as Meredith Whitney and billionaire Ray Dalio accurately predicted the 2008 financial crash. Before the crash, leading analysts were all over saying how good the economy was.
Again, no single analyst saw the oil crash that happened some years ago. Or when the SNB (Swiss National Bank) removed the currency peg, no analyst was on record to having predicted that.
Therefore, as a day trader, always make your own independent research and allocate capital bearing in mind the risks involved.
Trade few instruments
As a trader, the biggest risk you can put to yourself is trading many instruments. Big banks and hedge fund managers have achieved a lot by understanding that excessive diversification will lead to minimal returns.
For instance, banks such as Goldman Sachs have thousands of employees in their trading department. These employees are divided to focus on specific core instruments. There are people who deal with currency and others who deal with commodities.
As a day trader, the best thing you can do is to trade on two or three instruments. For instance, you can focus on the EURUSD pair alone. You can also focus on gold. Your end will come the point you start trading many currency pairs and commodities per day. The fact is that it is possible to make a lot of money by trading a single pair.
Don’t forget this: diversification is also an important factor in mitigating risk. If your assets all move in the same way, a drop in one will mean a drop in all.
Aim high
Another strategy to use is that of buying high especially when a good valued company reaches a 52 week high on good volumes. This is the point when institutional investors buys and increases their positions, thus pushing their prices higher.
We recommend that you scan for companies trading near or at the 52-week highs and then place a trade. Chances are that the price will continue going higher as more institutional investors gain interest in the shares.
Risk analysis
Day trading is usually very risky and people have lost a lot of cash. The problem with many day traders is that they don’t take time to perform risk analysis before they allocate their capital.
Risk analysis involves using mathematical tools to establish the amount of money you are willing to risk per trade. In short, the calculation of your risk-reward ratio.
Stop loss and take profits orders
One way to protect your finances is to use a stop loss and a take profit. When using a stop loss your trade will stop immediately the point where excess losses are made. Ignoring a stop loss is common especially for traders in denial.
They hope that the market will suddenly come up in their favour. Unfortunately, this rarely happens and they before they realize it, it is too late.
Trading Size
Another way of managing risk is through the trade size. A good way of doing this is to buy 20 to 50 shares of an Exchange Traded Fund (ETF). This allows you to make small profits or losses. Using large volumes can lead to serious consequences in a portfolio.
The noise makers
As a day trader, you should always be aware of the noise makers in the financial market. These noisemakers are the ones which bring volatility and uncertainty in the market.
Market and economic data are the most common noisemakers. To stay ahead of the game, We recommend that you download mobile applications such as one from Investing.com, Bloomberg and Market Watch.
Also, if possible, We recommend that you watch Bloomberg TV and CNBC to get information as it arrives. Or you could opt for tools made available by our partners at TraderTv: a watchlist in the morning and live YouTube broadcasts during trading hours.
The economic calendar will help you anticipate the market reaction and know when to trade and when not to trade.
Use the Chinese Market
China is maybe the most significant market in today’s financial market. Their markets open and close hours before the United States market open.
In many days, what happens in the Chinese market has a direct correlation with what happens when the United States market opens.
For instance, if the Chinese stocks fall significantly, it is always expected that the S&P 500, NASDAQ and the DOW will fall.
Therefore, as a trader, you can always go short the three if the Asian markets fall and vice versa.
Related » Opportunities When Trading Multiple Time Zones
Use the options market
The options market is an attractive way of trading a volatile market (here some tips for your strategy). One way of doing this is to buy puts for companies you own or know very well. This will help you protect your money in case of a downside.
Using options, you can also initiate a straddle especially when you expect the market to go up or down aggressively. Market volatility will always be there in the financial world.
Summary
For day traders, market volatility is your friend! It is during a volatile market that you are able to double or triple your investment capital. By considering the strategies above, you will anticipate the market and place great trades.
The market will always remain volatile and uncertain. Successful traders have always known this and use it to their advantage. As a new trader, mastering the art of financial analysis will help you navigate risks and allocate resources in the best way possible.
It does not however caution you from making losses but it will protect you from your account being wiped away.
External Useful Resources for Market Volatility
- Stock Market volatility: Think Opportunity, not Turmoil – Forbes