Take Advantage of Market Volatility with Derivatives Trading and Risk Management Strategies

Take Advantage of Market Volatility with Derivatives Trading and Risk Management Strategies

Source: BURSA ACADEMY | Published: June 2020

As the world begins to realise that the effects of the coronavirus outbreak are likely to persist well into the foreseeable future, markets everywhere are experiencing unprecedented volatility. The medical hazards posed by this pandemic are not without precedent but the scale of the economic turbulence it could trigger will most certainly be unprecedented.

The good news?

Increased volatility brings increased opportunity to profit in a shorter amount of time. But, inevitably, higher volatility also entails higher risks — it is a double-edged sword. With a spike in market volatility, the potential for above-average profits increases but you also run the risk of capital depreciation in a relatively short time.

With a disciplined approach to derivatives trading and doing your due diligence to mitigate the risks involved, the volatility can be to your benefit.

Risk Management

Bolster Your Defences

Risk management is paramount when you embark on trading in volatile markets. You must be mentally and tactically prepared to manage the risks, ensuring that you are comfortable with the level of risk that accompanies trading in such an environment.

The potential for significant loss of capital is ever present. The next prudent step then is to re-evaluate the risk control measures within your trading plan.

Two important considerations are position size and stop-loss placement. During volatile times, day-to-day price swings can be significantly greater than usual and some traders place smaller trades, committing less capital per trade and using a wider stop-loss than they normally would. The goal is to avoid getting stopped out due to wider-than-normal fluctuations within the day, while attempting to keep overall risk exposure as low as possible or at least at the same level. Traders should always remember that stop orders can be executed far from the stop price if there is a big price gap or rapidly changing market conditions.

To mitigate risks, consider using shorter term strategies. This usually involves attempting to take profits more quickly than on a normal basis. Since profits can turn to losses in an instant in a volatile market environment, certain adjustments to exit the trade more quickly should be made.

This can be done by setting a specific percentage profit target, selling a part of a position at the first good profit-taking opportunity and holding the remaining position in hopes of generating additional profits, using an overbought/ oversold type indicator (e.g., RSI), selling when it signals that the security is overbought or activating a trailing stop sooner than normal and/ or using a tighter trailing stop than normal.

Focusing on stocks trending with the market can also help manage the risk levels. In volatile markets, trending stocks might see the rate of their trend increase. This means that looking for stocks that are already trending in the direction of the overall market might give a trader the opportunity to generate profits faster than in normal or quieter markets.

However, keep in mind that all this still holds a potentially higher degree of risk. Crucial to this strategy is finding a stock that has been trending higher (if the stock market is on an upward trend) but which has not yet accelerated the pace of its advance. Conversely, a short seller trading in a volatile market should look for a declining stock that has not yet experienced a 'waterfall', a sharp decline. The goal here is to get in before any acceleration in price.

'Buying the breakout' is another method commonly used. In this strategy, traders watch for breakouts from consolidations; they monitor a stock trading within an identifiable support and resistance range. No action is taken as long as the stock stays within the range but, once the price breaks out on the upside, traders will look to buy the stock immediately.

The reasoning behind this is the hope that the breakout signals the beginning of a new upward trend for the stock. As in the stocks trending strategy, this uses the fact that, in a volatile market, prices move rapidly and an upside breakout might be followed by a prompt and substantial run to higher prices.

The potential held within the acceleration of prices is one of the main reasons to trade breakouts in a volatile market environment. However, the risk of a false breakout will always be significant, and traders should consider a stop-loss order to limit losses, as a reversal from a false breakout might cause more severe losses than in a quieter market due to larger price declines.

Derivatives trading

Once you have factored in the risks of trading in a volatile market environment, you can begin to look at derivative contracts, which is one way to build strategies to profit in times of volatility.

Calendar Spreads

A calendar spread is a simultaneous trade involving the same futures or options in which those expiring on a one date are bought and those expiring on another date are sold. It is a market-neutral trading strategy for capturing opportunities created by volatility.

The goal of a calendar spread strategy is to take advantage of expected differences in volatility while minimising the impact of movements in the underlying security that turn profits from a neutral movement to the price of the calendar spread. The technique is commonly employed for futures contracts in commodity markets. Futures trading is volatile, as most prices are affected due to external, uncontrolled macroeconomic conditions.  

Hedging

The idea of hedging probably originated from the planting of hedges, which act as natural fences for a property and limit the risks to the property. In much the same manner, hedging an investment protects an investor from being exposed to risky situations. However, it does not necessarily mean that the investment will not lose its value. Rather, hedging attempts to mitigate the losses through gains from another investment.

The practice of hedging led to coining of the term 'hedge fund' in an article that claimed that investors could make higher gains if hedging was implemented as part of a wider investment strategy. The phrase 'hedging your bets' is a reference to the attempts to reduce the risk to one’s investments.

To hedge, investors often use derivatives, which come in a variety of forms like futures, forwards, options and swaps. The most commonly used derivatives for hedging are futures contracts, which are two-party contracts that stipulate the price and time for buying or selling an underlying asset. The contract specifically addresses future conditions which have been agreed upon previously. By doing this, both parties can protect themselves, at least partially, if unforeseen changes affect the financial market.

Arbitrage

When derivatives are trading above or below their 'fair value', arbitrage strategies can be undertaken by buying or selling derivatives while simultaneously selling or purchasing underlying stocks.

An arbitrage strategy is another simple and clever way of seizing an opportunity to earn a higher price with steady profits. It involves buying an asset at a lower price and simultaneously selling the asset in another market for a higher price, a fairly common strategy used in market exchanges.

In real life, this concept now exists only for brief periods since arbitrage trading has been taken over by algorithm-based trading in the matured markets. With the help of algorithms, arbitrage can be spotted easily and captured for traders to monitor. 

Directional Strategies

Observing trading patterns and data on market announcements is crucial when estimating possible bullish or bearish trends that inform investors when to trade. This close observation allows for the right calls to be made.

In a bear market where a market decline is expected, the FKLI contract can be first sold and then bought again when the price declines, making a profit. In bull markets where an uptrend is expected, the FKLI contract can be used by buying a contract first and then selling it a higher price point.

 Higher profits will always be tempting to traders but, in a volatile market, the opportunities that price movements bring can quickly accelerate profits beyond what they are used to or expect. When market volatility reaches a certain level, things can move very quickly. Closer attention and quick changes in tactics might be necessary. The key is to prepare in advance and constantly re-evaluate your strategies. Always ensure that you are comfortable trading when volatility is high, that you have evaluated the potential for significant loss and that you are fully prepared for it.

Empower yourself with these strategies and go forth into an exciting market!

Tags: DERIVATIVES TRADING, DIRECTIONAL TRADES, MARKET VOLATILITY, RISK MANAGEMENT, TRADING & RISK

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