Week Ahead: Dealing with Range-Bound Volatility
Here we go again! Dow futures, and those of the other major indices, swung violently overnight. At one point, it looked like the industrial index would open with a continuation of the big drop Friday, showing an early loss of around three hundred points.
Then, they swung rapidly to the positive and are, at the time of writing, indicating a nearly three-hundred-point gain on the opening.
It is yet another example of something I have frequently said: traders overreact. There are, however, ways to take advantage of that, or at least to limit the damage it does.
It is hard to escape the conclusion that the market is being manipulated. The news around trade has fallen into a pattern. When actions are taken, stocks fall dramatically, then, after a couple of days of big losses, the President or someone else in the administration hints at something positive and traders rush to buy.
However, words are cheap and the rhetoric can change in one interview, or, more likely, in one tweet.
The result, as the chart shows, has been three weeks of the S&P 500 bouncing around in a range of 25500-26500, but investors should focus on the fact that essentially nothing has changed. Even from a longer-term perspective, the broad market is back where it was in early November of last year, before the big drop and rapid bounce that came from the last round of imposing tariffs then suggesting that an end to the trade war is in sight.
So, what is an investor to do?
Well, if you are someone who doesn’t mind trading a bit within your account, the obvious thing is to trade the well-proven range. If you do that, whether you use an index ETF or prefer the leveraged approach such as futures, there are a couple of things to keep in mind. The first is that the levels are approximate, and you should be looking to establish positions just below 26500 and just above 25500, not at those levels.
The second is that the only certainty here is that at some point, the range will be broken. When it is, it is likely that it will be part of a big move, so structuring a trade in anticipation of that make sense. That means that if you set a stop loss order based on a breakout, you might want to consider placing that order for more than your original position size.
Let’s say that this bounce gets close enough to the top of the range to warrant a short position at around 2635 and that your position is in five of whatever. The idea would be to place a stop-loss order at around 2660, but for ten. That way, if the breakout comes, you automatically reverse from short to long and can take advantage of the momentum that usually follows a breakout like that.
It should go without saying that there is always the possibility of a false break, so turning one losing trade into two is a possibility. That makes it important that if your double-sized stop is executed, you immediately set another stop just inside the old range to limit losses if that is what happens.
For most investors, however, while that kind of active trading approach may make sense, it is not for them. They either don’t have the time for the kind of close monitoring of short-term moves that it demands, or they simply don’t want to take on that kind of risk. In that case, sitting it out is the best strategy, and that is more about what you don’t do than what you do.
Mainly, in the words of the Hitchhiker’s Guide, don’t panic.
Even if you tell yourself you are a long-term investor and will wait out all the volatility, it can be hard to sit on your hands on days like Friday, when all the headlines are about the Dow being off over six hundred points. The trick is to turn that on its head and use the drop to add to a few positions. Similarly, if a big jump makes you think that everything is going to be fine and makes you feel a bit bullish, use that as a prompt to trim some things that have performed well. Mainly, though, take small actions to satisfy the urge to act without changing your overall exposure.
Always remember that this is not about to change soon. Even if we do break one way or the other, we will probably just establish another wide range with intraday volatility, but at another level. That is because there are contradictory forces influencing stocks. All the evidence suggests that even though trade is starting to act as a drag in some ways, the U.S. economy is still strong, and the consumer is driving much of that strength. But that strength looks fragile. Any escalation in the trade war puts it at risk, and when that danger is to the fore, there will be a selloff.
Most of all, don’t react to the news. Leave that to the traders whose job it is to overreact. The comments from both sides of this dispute are designed to manipulate opinion and essentially mean nothing. What counts are their actions, and so far, those actions have led only to more tariffs and more volatility. That won’t end for a while, so investors should have a plan to deal with it.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.