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5 CFD trading strategies to help you trade a volatile market

13:18, 30 April 2018

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Tip 1. Don't take unnecessary risk

First off, let's remember a prime rule of CFD trading strategies, don't take unnecessary risk. Why spend the weekend worrying about what's going on in Syria when you could have closed your positions out and come to it with a fresh mind when the markets reopen?

So, if the risk is that bad news is going to make markets unpredictable when you can't trade, then it's generally better to be out than in. That's the underlying basis for day trading strategies. Of course, if the piece of news that your trading strategy is based on is going to come out when markets are closed, then you're going to have to set up your position beforehand and holding it through to the open becomes a necessary risk.

Tip 2. Stop-loss orders and/or alerts provide (some) protection

Stop-loss orders on your CFD positions are a good way of handling trading risk in volatile markets.

You can place a stop-loss when you place a CFD trade and you can adjust it again later. If the price falls or rises above the set level, then an order to close the position will be automatically placed in the market and you will get the market price at that point.

However, you need to be aware of the limitations of a stop-loss. A stop-loss is simply an order into the market and so, apart from the automation, it is no different from you placing an order in response to price movements. If an overnight event causes the market to reopen at a much lower level, then you will get the price that the market next trades at. That could well be lower than the stop-loss level that you set.

An alternative is simply to place alerts to notify you when the price moves and then to assess the situation and place the order yourself. The latter approach is preferable, but its not always possible and the discipline of a stop-loss may be an important part of your CFD trading strategies.

Tip 3. Market neutral strategies hedge out some of the risks

Can you remove the unwanted market volatility? What about 'market neutral' CFD trading strategies? You've got a handle on the next set of company results, but the market's move could leave the stock flat on the day. So, hedge out the risk that you don't want to take. Go long on the stock and short the market or short the stock and go long on the market. You need to do a bit of math to make sure that you've got the scale right.

For example, if you wanted to go long on Lloyds Banking Group at 68p and short the FTSE 100 index of top UK companies (including Lloyds) at 7258, then you need to buy 1067 Lloyds Banking to balance against a 0.1 trade in the FTSE100 at £1 per point.

Clearly there aren't always good hedges; they either don't complement or contrast or the volatility is different, so that equal amounts invested don't produce the right balance of outcomes. However, it is nearly always a useful process to identify the elements of your trading strategies that you are happy with, but also the trailing edges of the trade, whether it be equity markets, currency or volatility, that could trip you up even if your central case comes good.

Tip 4. Understand the source of the volatility to understand the risk

So far, we've looked at volatility in markets and some trading strategies to avoid it. The next part is to understand the source of volatility. You want to distinguish the political crisis, which tends to lead to prices being marked down on thin volume as investors stay on the sidelines, from a market or economic crisis where investors rush for the exits. The best way is to look at the level of activity in the markets, using the appropriate set of data that is available for the market that you're looking at.

One of the ways to understand the difference between the two is to look at a 'false break'. At its most basic, a false break is when your technical assessment gives you a false signal, breaking above or below a resistance level and then backing off and reverting to the old trend as if nothing had happened. A classic rule of thumb to spot false breaks after the event is that the price is back inside the resistance by the close of the second day of trading. That signals that whatever the price action during the day, the weight of investor money left the trend intact by the reckoning at the closing bell. Such false breaks often signal a further move away from the resistance level and can be a good timing signal for a trading strategy to benefit from volatility.

In more volatile markets, one should reassess position sizes for your CFD trading strategies. Volatility is already guiding you in this, for example one might use no leverage when taking a position on an individual stock, but would be happy to use many times the leverage for trades in the much less volatile FX markets for the major pairs.

In a more volatile market you should adapt your trading strategy by reducing your position sizes or lowering leverage. You should also adjust stop-loss positions to either provide a wider margin to ride out short-term volatility or rather tighten them and accept being 'knocked out' by a minor move with scope to re-enter, depending on which is most appropriate for your trading strategy.

Tip 5. Keep faith in your established trading strategies

Having offered these tips for trading CFDs in volatile markets, it is worth emphasising that this is not a replacement for your established trading strategies. This advice is about trimming unnecessary risk in volatile markets. But this is to ensure that you can still continue trading. If you can maintain your discipline and focus, then patience can be rewarded with opportunities and significantly larger returns than normal.

Crises are like earthquakes, a build up of underlying pressure that can be detected but is impossible to tell when it will emerge. Then a series of shocks, a crescendo and then some aftershocks. For investors the aftershocks can offer a better combination of risk and reward, and provide a profitable return for patience.

Summary of CFD trading tips for volatile markets

  1. Don't take unnecessary risk. Avoiding holding risky positions when you won't be able to react to developments reduces risk. You can always reopen them later.
  2. Use stop-loss as a safety line. Alerts are better if you can monitor and trade. Remember neither can prevent losses when markets gap downwards.
  3. 'Market neutral' trading strategies. See if you can hedge out the risks that you don't want to take. Even if you can't you'll be more aware of those other risks that you are taking.
  4. Understand the source of the volatility. People are more predictable when it comes to their own investment positions than political positions on what should be done. Use this to your advantage by looking at the underlying flows of buyers and sellers. That is key to determining what is noise and what investors really think about prices in the market. 'False breaks' are a great example of the trading opportunities that arise.
  5. Keep faith in your established trading strategies. Discipline, focus and patience will help keep you out of trouble and bring opportunities to you.

And finally...

If you're still nervous, then why not take a time-out? You can always sit on the sidelines until the noise and confusion dies down. Perhaps watch what happened to your trading strategies in demo mode. Experience is valuable, it doesn't always have to be costly. As you gain experience you will find that you can see through the noise and confusion of market crises and, just like performing in front of a crowd, it becomes exciting rather than frightening.

To learn more on trading strategies watch our first video from "Easy-to-follow trading strategy" series.


 

Capital Com is an execution-only service provider. The material provided on this website is for information purposes only and should not be understood as an investment advice. Any opinion that may be provided on this page does not constitute a recommendation by Capital Com or its agents. We do not make any representations or warranty on the accuracy or completeness of the information that is provided on this page. If you rely on the information on this page then you do so entirely on your own risk.

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