How Wall Street Adjusts in Times of Higher Volatility
Wall Street loves nothing more than volatile markets. More movement means more trading, and ultimately more profit opportunities. The summer break has ended and a new period has just started in financial markets. During August many traders go out on a vacation, market volumes tend to decrease, equity movements are less pronounced and there are no major events occurring. In September all investors return to the market, volatility increases and corrections in prices frequently occur. The month of September is historically the second most volatile month, just below October. August is normally expected to be a quiet month.
This year, quietness is not the best adjective to describe what has happened during August. Stock markets were violently hit down with the FTSE dropping more than 7% and experiencing a trading range of 1,122 points that represents 19% of its July closing price. When looking at the last 20 years, this year’s August was the most volatile and the fifth most volatile when considering all months. A move like this was not seen since November 2008 as can be observed in the table below.
|Top 10 Most Volatile Months (Last 20 Years)|
|Pos.||Date||Month||True Range||True Range (%)|
But August was not only volatile but also a month of big losses. The FTSE 100 have lost 7.23%, the fourteenth worst monthly drop of the last 20 years, something not seen since February 2009 as depicted in the next table.
|Top 15 Worst Performing Months (Last 20 Years)|
The latest economic data coming from both Europe and the USA is a case for concern showing that manufacturing is almost not growing anymore, businesses are not willing to invest, the consumer is cutting on non-essential expenses, the job market is stalled, and GDP growth is tepid. Adding to all these problems, there is a growing concern over sovereign debt that is not just a European issue anymore. The USA has just been discussing on raising debt ceilings to be able to avoid a default on its obligations and the country saw its debt rating downgraded from the golden AAA to a less shiny but still credible AA+.
All these recent developments led to an increased uncertainty over the future, giving rise to concerns over the possibility of a double dip recession. As a result August was one of the most volatile months ever for shares. Instead of getting some hot sunbaths, many spread betting traders saw their portfolios been burnt by market volatility. And some of them were even worse hit when trying to pick the market bottom just to see their positions stopped over and over again.
When market conditions change that fast, spread betting traders should adapt themselves. Volatility is one of the most important variables a spread bettor has to master and control. It represents risk. When risk changes, the conditions under which a trade is set must be adapted. Professional Traders in Wall Street and elsewhere are very quick to adjust their strategies when markets enter times of turbulence. They realise that they must wait for a bigger expected edge in each trade, because of the increased likelihood for them to get run over by a stampeding market.
During August the daily trading ranges went up. At, 9th August, the FTSE moved in a range of 385 points and the Average True Range (ATR), an indicator that measures the average range trading over some period (in this example 14 days), went from 50-100 to 200.
What are the implications of the increase in ATR?
The ATR roughly shows how many points the market is moving on average in a certain time interval. This way, it helps in setting our stop orders. If the ATR is 50, it does not make sense if we set a stop order 25 points away from the entry point if we want to see our position still open tomorrow morning. Traders usually set stop orders that are away from entry points, two to four times the ATR.
Let’s now look at the chart below that plots the average true range for the FTSE 100 over the last 12 months.
The ATR has been between 50 and 100 for most of the time but rose over 200 in August. With the ATR four times higher, your stake per trade should be reduced four times, when keeping all the rest constant. If you want to play safely, your stakes should even be reduced more than proportionally to the increase in ATR since in such volatile times it may be wise to increase the ATR multiplier and reduce the risk per trade. The following table shows an example depicting the example.
|Normal Volatility||Higher Volatility||Higher Volatility – Defensive Action|
|Trade Risk Pct||3%||3%||3%|
|Trade Max Risk||£300||£300||£250|
|Stop Loss Pts||125||500||600|
|Stake per Point||2.40||0.60||0.42|
A trader with a £10,000 portfolio was risking 3% of its funds on any single trade and using a 2.5 ATR multiplier to set his stop losses. Since the ATR in FTSE 100 was 50 in calmer days, he was staking £2.4 per point. When volatility rose such that the ATR changed to 200, the spread betting trader should at least set his stop losses accordingly, meaning he would reduce his stakes to just 60p per point. A safer approach would be to also reduce the trade risk slightly and increase the ATR multiplier. The final result would be a further reduction in the stake per point. This way the trader is not assured of any profits but at least knows he is not risking too much in a single bet and that he won’t be stopped prematurely.
It is true that there’s nothing you can do about the past month of August but at least you can analyse it and be prepared for the future. The month of September started in the same way as August and volatility promises to remain in the market, so adapt your trading plan to avoid unnecessary negative surprises. Trading desks across Wall Street are adjusting their strategies, and you should too.