Friday, June 19, 2020

5 Tips for Trading High Volatility Stocks

NBHM Research Team

Trading Tips for High Volatility Stocks


While stock market volatility provides plenty of opportunities to trade, wild intraday swings can lead to losses. Here are 5 tips to manage volatility.


Stock market volatility has been on the rise ever since the coronavirus pandemic gripped the world, in January 2020. Globally, major indices lost 25% to 30% of their value between February 19 and March 20, 2020, in what is now being called “the stock market crash of 2020.” By April 8, 2020, analysts noted that the S&P 500’s average daily percentage change was +/-4.8% in the past 5 weeks, that kind of volatility not seen since the 1929 crash.

By mid-May 2020, the markets had been able to recover what was lost in February 2020. On June 6, 2020, the stock markets achieved record highs, on news of the US adding 2.5 million jobs to its economy in May 2020. As of June 16, 2020, volatility once again entered the market, as the US and China grappled with fresh surges in Covid-19 cases.


Trading in Volatile Conditions

Elevated volatility remains a major trend in bear markets like this, which often see short term rallies but remain in a downtrend. For many traders, surges in volatility spell trading opportunities. Traders who are on the right side of the price changes can make some gains quickly.

The higher the volatility of a stock, the more opportunities to earn. At the same time, high volatility also means higher risk. The time needed to capture gains is shorter, and price movements extremely unpredictable. Traders can lose a great amount of capital in a short period of time. In addition, more positions need to be entered into and exited, which means traders need to be efficient or risk losing significant amounts of capital in transaction fees.

Trading highly volatile stocks requires careful planning and trade management. Here are 5 tips to make the most out of trading in such conditions.


1. Avoid Overexposure to Any One Sector

A particular sector might be trading higher on a particular day. This doesn’t guarantee that it will continue to do so in future. Traders need to consider spreading their risk out, which means investing in 4 to 5 different that are not correlated to each other.

Stocks in the financial and energy sectors tend to be highly volatile. On particular days, while the market is rallying, it might be possible that the financial sector is marginally higher due to a new announcement made by the US Fed Chairman or one of the biggest banks beating earnings expectations. On other days, the reverse might be possible, so consider trading in defensive stocks like utilities or consumer staples, which remain stable, irrespective of the economic situation.

Another approach is to have an “Equity Market Neutral Strategy.” This includes taking advantage of differences in stock prices by taking both long and short positions in stocks from the same sector, industry, market cap or nation. So, traders can focus on price movements within a particular category. Positions can be spread out among high volatility and underperforming stocks.


2. Keep Position Sizes Low

A good way to keep risk under control while trading volatile markets is sizing down. Keeping a few good quality positions open could enable traders to concentrate and avoid emotional decision making. Trading with margin in a highly volatile market, when unpredictable price swings are common, can erode capital fast.

There is a higher risk of triggering stop losses in multiple positions, which can lead to more losses. Traders can always add on more positions if the existing ones are profitable.


3. Short Term Trading Strategies Could be Better

In volatile markets, profits can turn into a loss very quickly. So, trading strategies that include exiting positions quickly may be considered. The following adjustments may be considered:

  • Use specific indicators to determine overbought and oversold conditions, such as the Relative Strength Index (RSI), to take short positions when a stock is overbought. Keltner Channels can also be used to identify strongly trending markets.
  • Choose a specific profit percentage target.
  • Sell some part of the position at the first opportunity to take profits and hold on to the rest, in case the market inches higher. This can be considered if the stock closes strong for the day, and the trader considers holding the position overnight. The following morning, a portion of the position can be sold, and the rest can run on, to see if the momentum continues.
  • Use a trailing stop sooner than usual.
  • Raise stop-losses aggressively. For instance, stop loss can be placed below the 5-day or 10-day moving average. It can be placed below the support level for long positions or above resistance in short positions.


4. Trade in Large Cap and Low Beta Stocks

High volatility conditions can trigger massive selloffs. But during such high volatility, going long or short on extremely speculative small-cap stocks can be disastrous. A 3% to 4% selloff in the broader market could mean a 10% selloff for small-cap stocks. These are known as high beta stocks. Beta is a statistical measure of a stock’s correlation with the volatility of the broader market (such as S&P 500).

High beta stocks have a high positive correlation with broader market returns. This makes them highly profitable in bullish conditions, but extremely risky in market selloffs when they lose at an amplified rate as well.

Large-cap stocks can be less risky in comparison. This means stocks with a market cap of $80 billion or more, which make it easier to find ideal trading setups. When the market finally emerges out of its bottom, it will always need these large-cap stocks to rally for sustainable growth.


5. Look for New Highs in Stock Prices

Look for a good fundamentally valued stock, with growth potential that reaches a new high on the price, along with significant trading volumes. Traders can consider looking for stocks that are range-bound but breaking their trading range. When it breaks out of the range and starts moving higher, that is where institutional buying gains momentum and stability. This is also known as “buying the breakout.” Conversely, shorting a stock can be considered when the price breaks below a 52-week high level.

Strategies need to be re-evaluated based on changing market conditions. Finding the right stocks to trade is an essential part of trading in volatile markets. In such conditions, things can start to move faster than anticipated, which makes it necessary to prepare in advance and deploy the right risk management measures. Lastly, it’s vital to understand when to walk away.

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