U.S. equities are off to a shaky start to the fourth quarter, as the S&P 500 has pulled back more than 9 percent from its all-time highs last month. While long-term investors are hoping the recent sell-off is only temporary, seasoned traders recognize that periods of volatility like this are great opportunities for both buying and selling.
Here’s a look at five rules traders should use when trading a volatile market.
Volatility gets everybody excited, but this is no time to throw your strategy out the window. If you’re the type of trader that identifies entry and exit points using technical indicators like RSI or MACD, stick with that. The most important part of trading any type of market is to stay disciplined and consistent rather than make real-time emotional decisions.
Identifying clear entry and exit points prior to making a trade is a great first step. Another way to protect yourself on the downside is to place stop orders in case the trade breaks down. This is especially true if you are holding a position overnight. The last thing you want is to wake up and see one of your stocks gapping up or down in your face. A stop order won’t protect you from losses, but it will cap your risk.
Even the purest technical traders know that fundamental catalysts have the potential to override significant technical levels. In that same vein, massive buying or selling pressure can sometimes override a fundamental catalyst.
This is why it’s important to pay attention to securities that are related. A strong earnings report in Apple (AAPL), for example, may have you wanting to buy the stock. But if the other major tech stocks and indices are all trading down, that’s almost assuredly going to weigh it down. The same is true during rallies.
Regardless of your trading strategy, it’s generally a good idea to avoid using excess margin or taking extremely leveraged positions during volatile markets. The potential gains may seem alluring, but it’s simply too easy for these trades to go in the wrong direction fast. No trade is worth the risk of blowing up your account.
The heart of trading volatility is to take advantage of quick trend changes. Whether you’re relying on a technical indicator or simply watching for a stock to make new higher highs or lower lows, it’s critical to remain aware of signals that show when it’s time to start scaling back or reversing your position.
Just look at last week for example. Wednesday’s big down day was followed by Thursday’s rally, which was then given all back on Friday. The market completely reversed two days in a row. The best traders woke up Thursday morning, saw the market was going green, and traded accordingly, then did the same thing on Friday. To ride a volatile wave like this, you need to be willing to make quick decisions about your positions. The longer you wait, the more likely you’ll miss out on the trade.
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