Volatility trading tips

Volatility is an enticing prospect for traders – offering the opportunity of fast returns, if you’re willing to take on additional risk.

When the markets are on the move, here are a few tips to help you stay profitable while keeping your risk in check.

1. Use trendlines
2. Don't just follow the herd
3. Take your position on news early
4. Filling the gap
5. Venture a guess

1. Use trendlines

Trendlines are an invaluable tool for trading volatility. They enable you to cut through the noise and see the underlying trend in a market, even when it’s experiencing wide upswings and downswings.

Before you consider opening a position on a volatile market, draw some trendlines to ensure you know precisely how it’s performing overall. It’s also worth identifying where key levels of support and resistance are forming – remembering that previous support will often turn into resistance, and vice versa.

2. Don't just follow the herd

One significant cause of market volatility is the ‘herd’ mentality.

As more and more traders jump onto an asset, they drive its price further. This causes more traders to join the opportunity, which only adds to the trend.

While riding these trends can provide handsome profits, it’s rarely a good idea to trade only because of FOMO: the fear of missing out on a popular opportunity. Instead, make sure you do your research properly. Once the herd mentality turns, things can get ugly quickly.

Of course, you can also take a contrarian view if you think a trend lacks substance. However, markets can remain irrational for a long time. So before you trade against a trend, make sure that the opportunity fits your trading plan.

3. Take your position on news early

When major market events – such as NFP, interest rate announcements and more – occur, your best bet might be to stay out of any related markets entirely. However, if you do want to trade the fallout, you’ll want to ensure that you open your position before the release hits.

To make this work, you’ll need to do a lot of research so that you can make your call on how the release will affect your chosen markets.

It’s worth checking any other related releases that might offer a hint to the final figure. If you’re trading NFP, for example, you could try to get a gauge of overall employment for the month by checking the ADP employment report, jobless claims and more.

Once you’re able to make an educated guess about where the release will land, you can decide how it might play out across the markets. Remember, though, that analyst predictions for a release tend to be priced in early. If you think the analysts have got it right, there might not be much volatility at all.

4. Filling the gap

We’ve already seen how markets can ‘jump’ from one price to another when trading is closed overnight or over the weekend. Often, it will then ‘fill’ the gap by returning to its previous closing price.

In the above example, AUD/USD gapped 35 points over a weekend due to some poor economic data from China. But then, over the next 12 hours, it steadily climbed back up to its original price.

A simple way to trade volatility is to look for these gaps and trade the subsequent return to the pre-gap price. But just like any trading strategy, it doesn’t work every time. So be sure to place your stops and limits at reasonable levels.

5. Venture a guess

One potentially exciting and impulsive way to trade is to place trades around major economic news events. Trading news announcements can be risky due to the large moves that can follow a news release. Therefore, you should be prepared well ahead of time.

First of all, making sure you place your trade BEFORE the news event hits is one of the vital keys in doing this successfully. You can make an educated guess as to what the market will tell you before the event is released as well as make a logical guess as to which way the market will move based on your educated assumption.

As an example, consider the event that typically creates the most movement during any given month: the U.S. release of Non-Farm Payrolls. As a general rule, the USD/JPY (U.S. Dollar / Japanese Yen) typically has the most logical reaction to major US economic releases; that is to say that if data is bad for the US, the USD/JPY goes down, and if data is good for the US it goes up.

Analysts will also publish expectations for news releases like NFP. These are important because the market has likely priced in the expectations. If the expectations are met then traders should not expect too large of a move. Alternatively , if the announcement is way outside of expectations, then there could be a large move. You can find expectations and upcoming news announcements on our economic calendar.

Before NFP is officially released, there are a variety of economic indicators that also measure employment and can be used as guides to making an educated guess. By aggregating these pre-NFP releases and scoring them on their previous effectiveness, one can then venture a “guess” as to what NFP will reveal.

Since the educated guess calculated a bad result, the logical assumption would be to sell USD/JPY before the release. Of course, it is vital to use stops and targets as managing a wrong guess is paramount to saving the balance of your account.

The NFP report isn’t the only one that can be utilized in this fashion either. For instance, you could pull together Consumer Confidence data to guess what US Retail Sales might be, or compile inflationary data to guess the tone of a central bank’s monetary policy decision. The possibilities are endless.