5 Steps For Trading In Forex Market Volatility

Posted 06/05/2009, 9:00 am EST by Richard Lee from tradingmarkets.com

An increase in market volatility often leads traders to find a lot more trading opportunities. The huge market usually swings lots of potential for gain, but also for loss, especially if traders do not take the necessary precautions.

During times of volatility, traders need to adjust their strategy to compensate for erratic market. The FX Markets also provides a great section on their site showing traders which currency pairs are experiencing the most and least volatility that day.

1. Decrease in Leverage

During times of extreme volatility, losses may seem traumatic. With the average daily pip movement increased in volatile times, traders should be considering how their leverage will affect their trades. At a one percent or even a half percent margin, investors should be mindful of how much leverage, or even the size position being traded, can affect their portfolio.

In normal market conditions, placing a 2 lot position is fine when you are looking to make about 50-100 pips. During a more volatile time, when the potential loss is 100-200 pips, it stops being an effective risk to reward ratio. To compensate, traders should look to taking on smaller trading positions, in this case only one lot as opposed to the average 2 lot position.

2. Use Tighter Stops

Many traders are hesitant to use tighter stops in volatile markets because they see the large swings increases the likelihood that the position will be taken out. Having tighter stops can also provide great risk managers in times of extreme volatility. For example, on a EUR/USD trade, rather than setting an 80 pip stop to protect your position, consider placing a 50-60 pip stop. This will insure the protection of your currency position and if the stop is broken, there is a higher likelihood that the trend will continue lower and the stop took you out before you could potentially lose more money.

The width of the stop being set does depend on the currency pair being traded, as some pairs have wider ranges. In a Yen cross like the GBP/JPY or AUD/JPY, traders may be more likely to have wider stops as their average daily range is 50% more than that of the EUR/USD. With that said, stops during volatile market conditions should not be as wide as before. Instead of a stop of 100 pips below entry, traders may consider a 25 pip reduction and have a 75 pip stop.

Below is a chart showing the EUR/USD and the GBP/JPY on the same very volatile day in the forex market. The EUR/USD had an impressive range of nearly 600 pips! The GBP/JPY far dominated though with nearly a 2000 pip trading range.

NZD/JPY Weekly chart 2

3. Be Selective with Trades

In volatile market conditions, traders are often tempted to place an increase in trades as the market is going wild and they want to take advantage of all the trading opportunities. It is important to remember that in volatile times, losses are likely to be big. Before placing a trade, assess risk tolerance levels. How much risk is acceptable for the trader both psychologically and financially? It may be a good idea for a trader to shift their interest somewhere else until things settle down, instead of trading a violent pair.

4. Increase Discipline When Trading

During all market conditions, traders should follow their predetermined trading strategy. During volatile market conditions, it is important to use that same level of restraint and self discipline. Any set stops, contingency plans or risk management benchmarks must be adhered to without hesitation. This will help in defining how much risk is taken and should price action be uncontrollable.

5. Know Before You Go

It also helps a trader to know what is causing the current spate of volatility in the markets in order to be prepared for the unexpected. As such, an investor can accommodate their strategy to the market environment and not just the currency pair being traded. The first of these considerations is accounting for emotions in a market: is fear currently driving the market lower? Or is it buyer's mania that is keeping the bullish tone alive? Traders' overreaction and emotion tend to push markets to overextended targets. This fact alone creates volatility through simple supply and demand.

Volatility can also, and more than likely will, be sparked by economic events. In this instance, market participants may interpret fundamental data differently and not as cut and dry as the more novice trader. A perfect example of this is usually monthly manufacturing reports that are released in pretty much all industrial economies.

The classic scenario has the market honed in on a particular number for the month. However, traders young and old will sometimes wonder why the market sold off if manufacturing showed positive growth. The answer is simple. The market had a different interpretation and positions were violently reshaped and shifted. These tend to create great opportunities for some and horrible memories for others. Below is an hourly chart of the EUR/USD during ISM Manufacturing for October 1, 2008. Here we can see the huge price gap that occurred due to market volatility as well as the resulting trend.

NZD/JPY Weekly chart 2

Panic and erratic momentum can additionally be found in certain market environments. Not to be confused with fear or greed, panic selling and buying can create very choppy and relatively untraceable markets. These conditions will lead some to flip flop their positions while leaving others gaping at the fact that the position was right, only to be stopped out prematurely. These two common examples will create further panic and volatility as traders abandon their own individual strategy for the possibility of instant profits or stoppage revenge. As a result, a vicious cycle of volatility ensues until a definitive market direction can be established.

The simple rules above, and a task of getting to know the current trading environment, can empower every trader through the ranks. Although some relate volatility with difficult and untouchable markets, opportunities continue to remain abound in these less than attractive conditions to those focused and fortunate.

By following these five simple steps, trading in volatile market conditions should be a little simpler. Remember to adjust leverage based on volatility, stick to how much risk your trading plan already determines, use tight stops and don't jump into every trade that looks good.