Volatility begets volatility: how to trade in the wake of big sell-offs

Yesterday’s ‘best ever’ rally was, in some ways, to be expected. Big down days tend to lead to big up days. When it falls, the stock market often resembles a bouncing ball. Dropping a ball from a big height then sees a big initial bounce, and then another drop. Slowly, momentum begins to fade, and the bounces and falls get smaller.

This is often the way of sell-offs in the stock market. Initial extreme volatility slowly declines, and either gives way to more steady declines or a slow rally that recoups the losses. Sudden turnarounds such as December 2018, when the market bottomed on Boxing Day and didn’t look back for weeks, are relatively rare.

Market sell-offs don’t move in straight lines

These kind of moves have happened before. The best day since 1945 for the S&P 500 was 13 October 2008, which came after the collapse of Lehman Brothers. But this, as will be remembered, was not the bottom. Almost another 30% was wiped off the S&P 500 before it finally hit the low and began its rally.

It was a brave strategy to assume that last week’s straight line move could continue for much longer. Nothing ever moves in a straight line in markets, even the Apple stock price. Some kind of recovery, even if temporary, was likely. Few would have thought it would be so dramatic, but as the title of this piece notes, volatility begets volatility. We cannot go back to the quiet rally of late 2019, and in some ways the violence of last week’s move was the necessary counter to the slow grind higher from August 2019 onwards.

This is similar to 2017 and 2018. 2017 was a year of steady, endless gains for US indices. 2018, by contrast, was bookended by extreme sell-offs. While these dramatic periods eventually subside, trying to predict when is usually very hard, if not impossible. But they do not disappear too quickly.

The models, perhaps, for what happens next are October 2018-December 2018, and August 2019. In the first instance, the market bounced and sold off in several waves over the course of several weeks, before finally turning sharply to the downside. Arguably this might happen again if economic data worsens, governments and central banks fumble their response to the crisis, and the virus becomes far more widespread in Europe and the US.

The second example, from 2019, points towards several big up days followed by sharp sell-offs. In this case the bottom was hit early on, and follow-on drops did not test it, but it took around a month to resolve into a move higher, and even then late September and early October witnessed another drop before the next big leg higher got underway.

Rebound is good for bulls and bears

In a sense, this rebound is good for both sides. For the bears it helps to take some of the heat out of the sell-off, and allows the preparation of new short positions, or to lock in some gains (remember, it is usually impossible to realise all the gains on a successful position, since picking the exact low or high is very difficult).

For the bulls, it will be encouraging to see the market finally find a low, suggesting that, even if volatility continues for a while yet, that the market has stabilised, with the long-term trend beginning to reassert itself.

However you choose to trade this market, remember volatility is not a one-off event, which makes the use of stops and correct position-sizing all the more essential. Do not become wedded to a position – each trade is merely a test of a hypothesis, and if the idea is proved wrong, then the trade should be abandoned. Cutting losses and letting winners run remains, as ever, the crucial approach for a successful trading strategy.