Stock Market: Understanding And Dealing With Volatility
The last couple of weeks in the stock market came as a big surprise to many, and as such have been somewhat scary. Four digit drops in the Dow are numerically historical, but in percentage terms nowhere near the records but a week like last week, with big swings in both directions, felt like a disaster even though the Dow Jones Industrial index (DJI) finished the week down just five percent.
The reason, at least in part, is that there has been so little volatility in stocks for such a long period of time that traders and investors now seem unsure of how to handle it.
It is therefore a good time for a few basic guidelines as to how to look at and mitigate volatility.
Just a glance at the 2-Year, one day chart below for the Dow makes it clear how much the last week or so of price action has differed from what we have seen in the recent past. Look closely at the tail end of the chart, however, and it reveals something important about periods of volatility -- they are rarely one-directional.
In this case there is no more than two consecutive days in either direction at any point. In addition, as the chart below demonstrates, despite their seemingly chaotic nature, volatile periods in the stock market often conform to recognized patterns.
This time, I extended the chart’s timeline back to November of 2016, when, following the election, the rally really got going. I also plotted some simple Fibonacci retracement levels based on that sustained move from the low back then to the high around three weeks ago. Regular readers will be aware that even though Fibonacci levels are derived from an ancient math sequence and logically should have no bearing on markets, I believe they do for the reasons laid out in this piece, and this chart supports that contention.
Now it could be that it is a complete coincidence that the bottom of the move so far that prompted a major bounce back was right at the 38.2% retracement level that is the most significant in Fibonacci theory, but my experience would suggest that it isn’t. Fibonacci retracements work because traders pay attention to them, and always have. If enough people see 38.2% as a level at which to jump in and buy, a bounce is inevitable and that’s what we saw on Friday.
This points to the utility of Fibonacci levels for traders, but what it also does is to demonstrate to longer-term investors that even in the seeming chaos of a big correction, there is some logic. Of course, that doesn’t get you back the ten percent or so that you have lost in portfolio value over the last couple of weeks, but what it should do is to reassure you that this too shall pass.
Even once we recognize that volatile markets often follow patterns, however, there is still the question of how to deal with them. For long-term investors, as has often been said, the most important advice is to not be panicked into selling. Once you have mastered that, though, you should also be looking to add to your portfolio on big drops like this if you have available cash.
From that perspective, things like Fibonacci retracement levels have a purpose beyond reassurance. They can be used as level to trigger that buying. If you do that however, that shouldn’t mean that you just pick a level and buy.
Even though the chart makes it look like it would have been smart to jump in with both feet at the 38.2% level that is not usually the case. If you start to buy on a big drop it is best to do so gradually, averaging in over a period of at least a few weeks. Doing so means that any further declines are to your benefit as they enable you to buy things even cheaper, while if stocks bounce you have at least started buying at the low.
For those who trade in their accounts more actively the important thing to remember when it comes to handling volatility is that trade size should be adjusted. The volatility means that the parameters of a trade, the levels at which you will cut for a profit or loss, must be further away from your entry point than they would in quieter markets. But, if you do that with a full trade size you increase the total risk of the trade, probably beyond your comfort level.
Trades should therefore be adjusted based on where stop loss orders can be placed. If, for example, you usually place a stop on a day trade around 25 points from your entry, but you want to do so 50 points away to allow for volatility, cut the trade size in half to keep your potential losses the same. The same volatility that makes that necessary will allow you to run a profit further if things go your way, so the Risk/Reward on the trade stays constant.
Volatility can be scary, even for experienced traders and investors: to deal with it the most important thing to do is to put it in perspective. Understand that not only is it nearly always not as bad as it feels when looked at through the prism of history, but that it is also not as random and chaotic as it seems. Keep those things in mind and have a plan based on your trading or investing style and volatility becomes an opportunity to profit, not a reason to panic.