Navigating Periods of Stock Market Volatility

  • Navigating Periods of Stock Market Volatility "Stocks take an escalator on the way up and an elevator on the way down"

    How to trade stocks

    This trading cliché inevitably gets trotted out in periods of stock market volatility. Stated differently, the quote means bull markets tend to rise gradually and consistently (like an escalator) while bear markets are characterised by sudden, vertical drops (like an elevator).

    The recent price action in the U.S. stock market clearly illustrates this phenomenon. After experiencing a drop of nearly 20% in Q3 2011, the widely-watched S&P 500 index went nearly four years without experiencing even a 10% pullback (on a closing basis), the longest such streak since 2007 and the third longest since 1950; we saw a similarly strong rally in the correlated Dow Jones Industrial Average.

    That all changed abruptly when the calendar flipped to August 2015. Collapsing oil prices, fears about a slowdown in China (the world’s second-largest economy) and concern about a crisis in emerging markets has led to broad-based selling in stocks. Since retesting its all-time high above 2130 in mid-July 2015, the S&P 500 has dropped an intraday low of 1834 in a little over a month, creating nearly a 14% peak-to-trough intraday pullback so far. In other words, it’s clear that stock market volatility is back, and this increased volatility is creating a variety of trading opportunities in different markets.

    How Stock market volatility impacts the FX market

    In addition to driving global stock markets lower, the recent bout of global risk aversion has spilled over into the forex market. In environments like this, higher-yielding “risk” currencies, like the Australian and New Zealand dollars, often fall while lower-yielding “safe haven” currencies, like the Japanese yen and Swiss franc, tend to benefit.

    The chart below shows the recent correlation between the Australian dollar/Japanese yen currency pair (AUD/JPY) and the popular Dow Jones Industrial Average (DJIA) of U.S. stocks:

    Source: City Index. Note that there is no guarantee this correlation will persist in the future.

    China: the epicenter of the current volatility

    The current epicenter of the global economic concerns is China, which is showing signs of slowing down after decades of strong growth. Therefore, some traders might want to go to the eye of the storm and focus on trading that theme. China’s government has recently loosened some of the restrictions on trading the renminbi (CNY or CNH), but many FX traders prefer to focus on trading the currencies of China-dependent economies. In that vein, currencies like the aforementioned Australian and New Zealand dollars, as well as other Southeast Asian currencies and the South African rand, may offer the best trading opportunities.

    For instance, USD/ZAR is testing its all-time high near 13.75 as of writing. While the pair could see a short-term pause off this resistance level, the longer-term bullish channel remains intact as long as rates hold above about 12.00. Meanwhile, the secondary indicators are also painting a supportive picture, with the MACD trending higher above its signal line and the “0” level and the RSI holding in a bullish range above 50. Given the bullish long-term fundamental and technical catalysts, traders may consider fading near-term dips in USD/ZAR in order to take advantage of a strong trend that is independent of the major global stock markets.

    Source: City Index

    And what about EUR/USD?

    Meanwhile, the world’s most widely traded currency pair, EUR/USD, has been a surprise beneficiary of the recent market turmoil. That’s because, up until recently, many traders were confident that the Federal Reserve would raise interest rates in its September monetary policy meeting, whereas the European Central Bank (ECB) is at least a year from even considering normalising its monetary policy. Therefore, it became a consensus trade to sell EUR/USD in an attempt to front-run the Fed’s “inevitable” interest rate hike later this year.

    Now, the global market turmoil has forced all of these traders to run for the exits at the same time, driving EUR/USD up nearly 1200 pips from its 12-year low to trade at a high above 1.1700 thus far. When and if the present fear in the market fades, the divergence between monetary policy in Europe and the US could prompt EUR/USD to resume its downtrend, but as long as anxiety is elevated, EUR/USD may hold on to its counterintuitive strength.

    How else can traders take advantage of volatile stock markets?

    Beyond the forex market, there are many other ways to play the recent stock market volatility. Most obviously, traders could simply embrace the volatility and trade CFDs on individual equities and indices. However, it’s important to recognise that these instruments may see larger and faster moves than traders have grown accustomed to over the last several years. One tool that traders can use to help navigate volatile markets is the Bollinger Bands indicator.

    Basically, Bollinger Bands plot standard deviations above and below a moving average, and they are often used to identify overbought or oversold markets. Assuming a normal distribution, price “should” stay within between the upper and lower Bollinger Bands about 95% of the time using a the default two standard deviation setting for the bands. Volatility tends to come in waves, so market prices don’t necessarily follow a normal distribution, but a move beyond the upper or lower Bollinger Band still highlights an extreme movement in the underlying instrument that may be more likely to reverse.

    Traders can also use the width of the Bollinger Bands, or the distance between the upper and lower bands, to measure volatility. The width tends to contract in periods of low volatility (as the standard deviation falls) and expands in periods of high volatility (as the standard deviation rises). Given the tendency for volatility to come in waves, a contraction in the Bollinger Band width is often followed by period of higher volatility and a corresponding large move in price.

    Source: City Index

    As the above chart shows, the Bollinger Band width on the FTSE index has expanded dramatically of late, signaling a big outbreak of volatility. A trader who had become accustomed to using certain set stop losses and profit targets in low volatility conditions would likely need to modify his strategy in the high-volatility periods following these events. For instance, it may be prudent to reduce the size of each position and use wider stop losses to accommodate the potential for larger moves on a day-to-day basis.

    Whither commodities?

    Beyond stocks and forex, commodities can also present attractive opportunities amidst highly volatile markets. As a general rule of thumb, growth-dependent commodities like oil, copper, and other base metals often underperform in volatile, risk-off markets. This theme is playing out in spades with the most recent outbreak of volatility: Crude oil (both the WTI and Brent contracts) and copper are both hitting their lowest levels since the Great Financial Crisis of 2007-2008.

    On the other side of the coin, gold tends to benefit amidst global economic uncertainty and volatility. The yellow metal is seen as a safe haven given its long history as a store of value. Traders who anticipate the current volatile market conditions to linger may want to consider the merits of gold, though any attendant strength in the value of the US dollar could serve as a headwind for the metal.

    Of course, there are many ways to take advantage of the recent outbreak in stock market volatility beyond just these few examples. Traders are encouraged to identify their own correlations and stay tuned to City Index for daily updates throughout the current bout of market volatility and beyond. Even when the stock market eventually stabilises, traders can still keep their eyes out for opportunities to take advantage of technical patterns, fundamental trends, and country-specific announcements.

    Remember, all traders incur losses from time to time. The most successful traders stick to their strategies and employ the technical, fundamental and risk-management tools at their disposal to try to ensure that their potential profits outweigh their losses.

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