Experienced traders have learned that global financial markets oscillate between periods of low volatility and period of higher volatility. While these different volatility regimes can be specific to a certain market (stocks, bonds, commodities, FX, etc), it’s common to see the magnitude of market movements impact all financial markets at once. In other words, when the stock market is more volatile, we often see bigger price swings in commodities and currencies as well, given the interconnected nature of the global financial system.
In higher volatility environments like we’ve seen lately, the FX market offers several advantages over other markets, but traders must practice good risk management strategies to capitalize on these opportunities.
Advantages of Trading FX Through Volatile Environments
First, and perhaps most importantly, the FX market is the largest financial market on the planet, with daily volume in excess of $5 trillion dollars ($5,000,000,000,000). This creates unmatched liquidity, or the ability to buy or sell quickly at the current market price. When other markets experience outbreaks of volatility, liquidity often dries up, making it more difficult to transact at the advertised market price.
Second, the FX market is open 24 hours a day, 5 days per week. These extended hours allow FX traders to enter and exit positions at any time during the week; by contrast, the stock and bond markets are typically closed for at least two thirds of the time. Global political, economic, and social developments don’t necessarily adhere to a traditional 9:00-5:00 schedule, especially when traders are not as focused on developments in North America, so the ability to trade at all hours is a key advantage offered to FX traders relative to other markets, where participants risk being stuck in trade that may see an adverse price “gap” while markets are closed.
Finally, the FX market is a two-way market, meaning that it’s as easy to sell any currency as it is to buy. This advantage is particularly pronounced during bear markets, when most stocks are falling in concert with one another, regardless of the quality and long-term prospects for the firm. In those types of environments, it can be difficult to profitably buy any stock, whereas FX traders can more easily take advantage of market trends by trading currency pairs in either direction. While it is possible to short stocks as well, traders often need a special type of account and regulatory approval to do so.
Risk Management Strategies to Navigate Volatile Markets
Regardless of which market you’re trading, there are at least three major risk management considerations for trading through volatile environments:
Generally speaking, traders may want to consider decreasing their position sizes, widening out stop losses, extending profit targets, and decreasing holding periods in volatile markets. Whereas EUR/USD moved an average of about 65-70 pips per day through 2019, an historically low volatility period, the pair saw average daily ranges in excess of 150 pips through 2009, 2010, and 2011, amidst the Great Financial Crisis and Sovereign Debt meltdown. If a trader developed a strategy to capture the majority of a single day’s movement – say 50 pips in EUR/USD during 2019 – he or she would want to consider using a wider stop loss and profit target and/or smaller position size when EUR/USD reverts back to moving more than 100 pips per day. In addition, certain short-term trading techniques and currency pairs could become potentially more profitable when market movements increase relative to the size of the spread between buy and sell prices. Constantly monitoring market conditions and making adjustments to established strategies can allow traders to stay ahead of the curve as the market’s volatility regime changes.
In more placid markets, traders are less likely to experience “slippage” on market orders, where the trade executes at a different price than anticipated. However, when markets are more volatile, it becomes far more important to utilize stop and limit orders to ensure that trades are executed at the intended price. Though it can be more work, diligent order entry allows traders to maintain favorable risk/reward ratios regardless of how fast markets are moving.
A full examination of trading and risk management strategies through different market environments is beyond the scope of this article, but readers are encouraged to explore the education section of our website and reach out to us for a session of consultancy
The sheer size, trading hours, and two-way nature of the FX market make it particularly attractive to traders, and by tweaking their strategies, understanding order types, and continuing to learn, traders can maximize their chances of successfully navigating volatile market environments.
By Suren Subramaniam | 22 September 2020