Trading Educators Blog
Volatility
Joe! The markets seem to be so volatile. It's really scary with all those wild swings!
I don't usually write about investments, but the question has come up with regard to volatility. The tricky thing about volatility isn't its wild swings. It's that we want to believe these wild swings are meaningful, and they're not.
With reverence to colored bars and candles, when we see lots of green in the markets, our brains tell us more good times are ahead. When we see lots of red in the markets, our brains tell us there's more pain to come, but we know only one will prove to be true.
So, when we see a big up day followed by a big down day, then another big up day followed by another big down day, we struggle. Our brains want to fit the price action into a rational model, a sensible big-picture view of what's going on. But there isn't one. How do you overcome this challenge and make money?
Volatility is uncertainty. It doesn't allow us the luxury of following a rational, knowable script.
Fortunately, we don't need to know the script in order to make good trading decisions. We simply need to stick to the basics: asset allocation, position sizing, and stop losses.
Let's review these basics and look at how we can use them to survive and thrive in this volatile market environment.
Let's start with the most important of the three - Asset Allocation.
Asset allocation is the component of your wealth plan that deals with the amount of money you have in various assets. How much of your wealth is in cash? Stocks? Precious metals? Real estate? This all goes under the umbrella of asset allocation.
The No. 1 goal with asset allocation is to avoid taking too much risk in just one asset class because when one asset class "zigs," others will "zag." In this way, effective asset allocation allows you to sidestep financial disaster.
I recently showed one of my students that based on a historical study of similar conditions to today's, the stock market could soar 23% in six months and 34% in the coming year. And lo and behold stocks popped higher.
But soon after, the markets were down a lot.
That's volatility for you. Don't let today's swing convince you that you shouldn't hold stocks. Instead, beef up your allocation to "disaster insurance."
When people ask me about investments, I recommended you hold at least 5% to 10% of your wealth in precious metals, at least 10% to 20% in cash, and whatever you're comfortable with in real estate and other commodities.
You'll know you have the right asset allocation when big drops in stocks don't freak you out. Your losses in stocks will be partially offset by your gains in other assets. So, you'll be a lot less likely to make bad, emotional trading decisions.
Next, let's think about the best way to use position sizing to your advantage.
Position size is simply the percentage of your portfolio (or the dollar amount) that you allocate to a single position. A stock could make up 1% of your portfolio, for example or 10%.
Obviously, you stand to make a lot more money if a 10% position makes a big move in your favor. You stand to lose a lot more if it goes against you.
Pullbacks are often fantastic opportunities to open new positions. But if you start with a big position, the volatility is more likely to get inside your head and cause you to sell at the wrong moment.
Instead, start with a small- to medium-sized position. Then add to that position as it moves in your favor. Or, if you're uncomfortable with the timing of your trade, but you like the idea, you can consider selling a put rather than buying shares outright. This way, you'll lower your cost basis if you're assigned shares, reducing your risk. And because you earn cash up front, you can profit on the trade even if the stock doesn't rise.
Finally, you can't make a good position-sizing decision until you set your stop loss. A stop loss is a predetermined point at which you'll sell a trading position if it reaches a certain level, no questions asked. Stop losses are designed to limit investing risk and to remove emotions from your trading decisions.
When you use a "tight" stop loss (close to the current asset price), you risk losing less, but you increase your odds of stopping out and taking that loss. When you use a "wide" stop (further away from the current price), you risk losing more, but you decrease your odds of stopping out, because the position has more "wiggle room."
The type of stop loss you use should correspond to your confidence in the timing. If you think you're buying at the perfect time, you don't need to risk 20% on the downside. A 5% to 8% stop loss may be enough. If you're less sure of the timing, but you know you want to hold the position for a long time, it makes sense to use a wider stop loss. Maybe 15% to 25% is appropriate.
When prices are very wild, volatility will likely knock you out of positions you open with tight stop losses. So, lean toward using wider stops and smaller position sizes.
In review, the three keys to surviving and thriving in today's market are:
- Beef up your allocation to financial-disaster insurance.
- Start with small position sizes. And add to those positions only when you're showing gains.
- Use wider stops to allow for volatility.
And here's a bonus: If you're still uncomfortable with a new trade idea after you apply those three keys, pass on the trade altogether. There will always be another trade. Follow this advice and you'll sail through the current volatility with ease.
Sign up for our FREE weekly Chart Scan newsletter.
Master Trader Joe Ross wants you to learn trading and he created products to do just that, teach you how to trade. Visit our website to find which ones best fit your trading style. Let's learn the art of trading Joe Ross' way!
Comments