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A survey of the geopolitical and economic landscapes concludes that there are many uncertainties early this new year and several potential landmines of volatility. Sure, on some level, it seems that this has constantly been the case, especially since early 2020. However, while markets have displayed the tendency to adapt, it’s always good to take inventory and do a volatility pulse check to determine how fit you are for what may be around the corner.
Let’s face it, we continue to have less data than we’d prefer concerning COVID19, and what’s worse is there is no crystal ball in terms of what type of variants or further dilemmas could arise. Also, the U.S. Federal Reserve Bank and other central banks worldwide are making further headlines concerning monetary policy.
Then, there’s the ongoing commodity spike, inflation, the housing market, and political and military concerns, leading to a lot of uncertainty in the markets.
I’m not pushing panic or fear buttons. I’m just saying it’s good to be ready. The past two decades have given us no shortage of market-moving events. From the 2008 credit crisis to various commodity and currency moves, that tells us there is always something waiting to happen.
When preparing for what may and could happen, these six following questions can help determine your overall readiness.
You should use this initial question as a guide to reflect on how confident you are in your recent trading. Of course, there is a distinction between confidence and competence. However, they should be correlated. If not, then there is a problem to address, and until your confidence (or lack thereof) and your competence meet, you are less likely to be successful in volatile markets.
It should go without saying that if you are suffering from a lack of confidence, it’s better to forgo trading volatility regardless of your performance. However, if you have been trading with confidence, the first sub-question to ask is if your profit matches your confidence. If you are trading competently and have healthy confidence, you are more ready to trade volatility.
The primary issue is overconfidence. Overconfidence is often the result of having a recent winning streak or an unusual profit return in a short space of time. The problem with overconfidence is that this usually creates a recipe for disaster when combined with a volatile market.
Now is a time as good as any to self-reflect and inquire about your confidence levels so far in 2022.
The second question is crucial to determining how fit you are for volatility trading. Of course, every trader should have rules, and if you don’t, you should seriously consider avoiding volatile markets. However, if you have rules, now is an excellent time to explore how well you play by them.
Are you prone to negotiate, violate, and dismiss the rules you’ve established to keep you safe? If so, I suggest you have more work before venturing into serious volatility trading. If you have set reasonable rules and stick to them, your chances of surviving and thriving in highly volatile circumstances improve tremendously.
One pitfall that I’ve observed even good traders fall into is having too firm of a bias. Success tends to generate a stubborn bias, but so also does ignorance. I think we have all been there, holding onto a view of a market when the price action has determined we are wrong. Many times, prideful traders will blame the markets for being irrational rather than blaming themselves.
We all have biases, but the key is to own our tendencies and try as much as possible to allocate them appropriately. Bias is only as good as the most recent price action. I’ve seen traders who had a strong bias and still lost money. The primary key to having a bias is knowing when it is wrong and not being afraid to admit it.
In my opinion, the quickest way to measure a trader’s likelihood of success is to calculate their risk-to-reward ratio. Too frequently, I’ve observed traders who risk a factor of 2 to make 1. The problem is, to be successful, you need to trade with size and have an exceptional winning percentage. Another issue is that an 85% winning strategy will inevitably produce a series of losers. Accordingly, to make up for that loss will mean an even greater winning streak.
When trading volatility, the need to risk less and earn more is a substantial factor. Volatility trading means you can get stopped out quicker and with greater frequency. Therefore, you must risk less. However, you can catch a huge move; hence, you need to target wider.
Okay, you wouldn’t just trade volatility on a whim, would you? Or is your plan hope and a prayer? I can assure you that some traders are eager for volatility but fail to plan for it. They hear all the lovely stories concerning easy profit and expect to approach volatile markets the same way as normally functioning markets.
The truth is, the charts print somewhat differently in volatile times. Meaning what you can generally watch unfold at average speed is hurried in volatility. Therefore, you must process information at a fraction of standard time. Unfortunately, this also means your P/L will fluctuate more extreme, and perhaps most severe will be your mental and emotional fluctuations.
Having a plan for volatility trading is a must. It is like driving a dark road without headlights. Don’t do it!
This may initially read like an obvious question. However, there are several facets and deep nuances to explore. First, the physical capital is a relevant question, do you have enough? If you are trading a small account (and I realize small is relative), volatility can break you. This type of trading is frequently employed most successfully by traders who have comfortable money to risk. The key is, is if you are in a position to become uncomfortable with your trades when they quickly don’t go your way, then you likely don’t have the physical capital necessary for volatility trading.
Secondly, you should also consider the mental and emotional capital as well. Each of us may have other business matters, relationships, responsibilities, and obligations in life that utilize our energy. The potential problem is that high volatility trading can be rewarding and stressful simultaneously.
I’ve known successful traders who had huge winnings who couldn’t seem to settle their minds or adrenaline and found it hard to sleep. And, when they did sleep, they dreamed about trading. Furthermore, there may be some emotional areas of life demanding much out of you. If any of this is you, then you might consider that your mental and/or emotional resources are already exhausted, perhaps delimiting you from volatility trading.
In conclusion, it’s best to keep a professional mentality when approaching volatility. This means that longevity is the most crucial attribute. Therefore, capital preservation and limiting your losses is the key to survival. It’s much better to sit aside and miss out on potential profits during periods of volatility than it is to trade unprofitably with the satisfaction of knowing that you participated in volatile markets.
The considerations in this article are pertinent to any moment of reflection in a trading career, but perhaps all the more necessary right now. So keep working and improving, and be ready when volatility arrives!
Stay safe and trade well. Until next time!
