However, panicking during volatile conditions is the last thing you want to do. To an extent, volatility can even play to your favor as a trader.
Volatility: Causes and Effects
Volatility is simply explained as the severity and frequency of change in the value of an asset over a certain period of time. It is mostly associated with the stock market but it also applies to different markets, such as foreign exchange or commodities. Regardless, a market with low volatility means there isn’t much change in the price of an asset, certainly not enough to stir a panic. High volatility, on the other hand, indicates wide price fluctuations and heightened risk for investors.
Volatility occurs when there is an imbalance of trade orders. Panic selling, for example, can trigger a sharp decline in stock prices, while panic buying can cause prices to shoot through the roof. What causes volatility, then, is the sentiment of investors that leads them to behave in a certain manner. This is influenced by a couple of factors, including economic and socio-political developments. Announcements from the central bank, inflation, and elections fall under this category. Company developments also influence the value of a certain stock. A change in corporate leadership or announcements of a new product can trigger investors to take a bullish or a bearish view on the asset.
High volatility also has negative effects on the trading process as well. Because of the high volume of trading, execution of orders might be delayed. Actual prices might vary from the quoted prices from when the order was placed due to the delay in execution. Or worse, high trading activity might make it difficult to place trades in a timely fashion or even access online trading accounts. To prevent these from happening, the U.S. stock exchanges set up circuit breakers to temporarily pause trading activity during turbulent times. This happened several times in March as investors panicked over the coronavirus outbreak which fuelled market volatility.
Taking advantage of volatility
That said, volatility isn’t necessarily something to fear. In fact, any trader with enough experience will tell you that price movements, whether positive or negative, present more opportunities to turn a profit. This is especially true for short-term traders like day traders or swing traders who take advantage of price fluctuations. Risk moves in both directions — while volatility might mean a greater potential for loss, it can also magnify the potential for rewards. Of course, the key is making an accurate prediction of how an asset’s price will move. Short-term traders who bet on price swings use different volatility indicators to determine the best position for their trade. These indicators let investors properly time market highs and lows so they can enter and exit as necessary. Or, it can also be used to justify shorting a stock or as a hedging strategy.
Another way to take advantage of market volatility is to trade derivatives instead of the underlying asset. Stock CFD trading, or trading contracts for difference, allow you to speculate on stock share prices regardless if it’s an uptrend or downtrend. For instance, instead of risking exposure in a falling market, you can profit from CFD trading by speculating on the downtrend using volatility indicators. Trading options is another way to use volatility in your favor over shorter periods of time.
Whether you’re trading the primary asset or its derivative, it’s important to understand that market volatility is an inevitable part of trading. For short-term traders, it’s actually a welcome component because stagnant prices limit the potential to generate profit. But if you’re taking a long-term approach by investing, avoid panicking in turbulent conditions. Continuously review your risk tolerance and rebalance your portfolio, while also getting comfortable with riding out highs and lows.