Trading volatile markets
Managing risk in volatile markets
Managing risk is always important when trading, but even more so in volatile markets where there’s tendency towards sharp price movements.
In this lesson, we’re looking at important measures to put in place to protect you from severe losses, as well as common mistakes traders make when trading volatility and how to avoid them.
How can I manage my risk when trading volatility?
Many of the risk management principles that apply to volatility trading are the same for any type of trading. These include:
- having a trading plan and sticking to it
- using leverage wisely
- understanding your market thoroughly before starting to trade
- practicing your strategy in a demo account and making use of stop orders
However, they become even more important in volatile markets because of the increased market risk.
The first step for traders looking to capitalise on volatility is to consider their own risk profile and tolerance. If you’re uncomfortable with the thought of losing even a small fraction of your trading capital, trading volatility is unlikely to be a good fit for you. If you’re willing to accept potential losses for increased opportunity for reward, read on.
In volatile markets — when price swings are typically greater than normal — some traders commit less capital per trade by placing smaller trades. The appropriate position size for each trade is based on the trader’s risk tolerance and account size. They use a wider stop-loss than they would when markets are quiet. The goal is to avoid getting stopped out due to wider-than-normal price fluctuations while also attempting to keep your overall risk exposure about the same.
Stop-loss orders
It’s always advisable to implement stop-loss orders to limit potential losses on trades. While a stop-loss order specifies a price at which a trade will be automatically closed to prevent further losses, when you’re trading volatile markets, you might consider using wider stop-loss levels to account for increased price fluctuations. Learn more about setting stop-loss orders.
Did you know?
Guaranteed stop-loss orders offer extra safety by guaranteeing that a trade closes at a set price, no matter what's happening in the market. They shield traders from sudden market jumps or slippage*. However, using them usually incurs an extra cost when triggered. On the IG platform, how much a guaranteed stop costs depends on the market you are trading, but you’ll only be charged if the stop is actually triggered. You can see the guaranteed stop cost before opening a deal. Just enter your stop distance (being sure to select ‘guaranteed’ from the drop-down list), and the stop premium will display near the bottom of the ticket.
*Slippage is when the price at which your order is executed does not match the price at which it was requested. This happens when the market moves against your trade and, in the time it takes for your broker to process the order, the original price set is no longer available. Slippage is more common in volatile markets.
Hedging
Hedging is when you open additional positions to offset potential losses from existing trades or investments. For example, you might try to hedge your exposure to a volatile asset by taking a position in a correlated asset or using options or futures contracts. Many volatility traders develop trading strategies such that a loss in one investment is offset by a gain in a derivative. Find out more about hedging.
Diversification
Diversification is a way of managing your risk by allocating capital in a way that reduces your exposure to any one particular asset or risk. You can diversify by spreading your trading capital across multiple assets or markets to reduce concentration risk.
Volatility-based strategies
Volatility traders often focus on developing trading strategies specifically designed for volatile markets, such as breakout trading in which traders capitalise on significant price movements in a financial market that happen when an asset’s price breaches its trading range. Read more about breakout trading. Other common trading strategies that may work well in volatile markets are day trading and scalping.
Common volatility trading mistakes
Common mistakes traders make in volatile markets include:
- Overleveraging: Using excessive leverage can amplify both profits and losses. In volatile markets, this can lead to significant losses.
- Not putting risk management in place: Failing to implement proper risk management techniques, such as stop-loss orders or position sizing, can expose traders to unnecessary risks. This is true for any form of trading, but especially so in volatile markets.
- Letting emotions dictate trading decisions: Your emotions can affect the clarity of your thinking, and this can impact any trading decisions you make, whether the emotion is fear, greed, sentimentality or confidence. Emotional trading often leads to impulsive actions and poor risk management. Being disciplined in sticking to your trading plan – no matter how you’re feeling – is far more likely to pay off. Read more about trading psychology.
- Chasing price movements: Trying to chase rapid price movements in volatile markets without proper analysis or strategy can result in losses. Again, the key to success is to have a smart trading plan and to stick to it – no matter what the price does.
Trying out volatility trading
To get a feel for trading in volatile markets, try it out in your demo account.
- Select a volatile asset or market: Choose a volatile asset such as a currency pair or volatile stock for your demo account exercise. While any market can experience volatility, some assets are naturally more volatile than others and move by greater percentages in a normal day. For example, minor and exotic forex pairs, such as currency crosses containing currencies like the Mexican peso, Turkish lira or Russian ruble, tend to show high levels of volatility.
- Define your risk tolerance: Determine your risk tolerance and establish a maximum percentage of your trading capital that you are willing to risk on each trade. For example, you might decide that you are not willing to risk more than 1% of your total trading funds on any single trade.
- Set stop-loss levels: Identify key support and resistance levels on the price chart and set appropriate stop-loss levels for your trades to limit potential losses.
- Practice hedging: Experiment with hedging strategies by opening both long and short positions on correlated assets to offset potential losses from volatile market movements.
Practical example: In your demo account you could start by opening a long position (buy) on EUR/USD, buying 1 standard lot (100,000 units) of EUR/USD at 1.2000. To hedge your long position on EUR/USD, you need to find a correlated instrument to short (sell) that will move in the opposite direction. To hedge, you might choose USD/CHF, as it tends to have a strong negative correlation with EUR/USD. In your demo account you open a short position (sell) on USD/CHF to hedge your long EUR/USD position and sell 1 standard lot of USD/CHF at 0.9000. Now, with a long position on EUR/USD and a short position on USD/CHF, if the EUR/USD pair increases in value, your long position will generate profits, while your short position on USD/CHF will incur losses. Conversely, if the EUR/USD pair decreases in value, your long position will incur losses, but your short position on USD/CHF will generate profits. - Monitor and review your trades: Keep an eye on your trades and regularly review your performance to see how you can improve your risk management approach, and adjust your trading strategy based on your observations.
Lesson summary
- The first step for traders looking to capitalise on volatility is to consider their own risk profile and tolerance.
- In volatile markets, some traders place smaller trades and use a wider stop-loss than they would when markets are quiet.
- To manage risk, traders need to pay attention to position size and set up stop-loss orders to manage risk.
- Volatility traders might also look to hedge their trades and to diversify their trades to protect against concentration risk.
- Common mistakes volatility traders should try to avoid include: overleveraging, ignoring risk management, trading emotionally and chasing price movements.
2006-2024
