The increased volatility in the markets means retail futures traders should take smaller positions and remain disciplined in their strategies.
September 16 has seen a large amount of liquidity in the markets since it is triple witching day when equity options, equity futures and index options and futures contracts all expire.
Futures traders must not deviate from their original strategies even as volatility picks up, said Peter Borish, chief strategist with Quad Group, a New York-based financial firm.
“One is in the trading business to make money and are not in the business to be right,” he said. “The most important thing is to maintain your discipline.”
Making smaller trades is important, because the market does not “go straight up or straight down, particularly when volatility expands,” Borish said.
When traders have an opportunity to take a profit, they need to take advantage of the opportunity. Otherwise, “what happens to many people is you end up turning a profit or small loss into a large one,” he said.
One major mistake retail traders commit is attempting to pick the top and wanting to be right, Borish said.
“It happens to many people and under no circumstance should you use volatility as an excuse to lose your discipline,” he said. “Too many people get greedy and they stay in a position too long and don’t take profits or continue to stay short. If they sell a position and it starts to go back up, they still stay in the short.”
Traders need to stick to their original trading plans and understand their own goals and risk tolerance, said J.B. Mackenzie, director of futures and forex of TD Ameritrade, an Omaha, Neb.-based online broker. When there is increased volatility, defining your risk upfront will help.
“This is a 24-hour market and news outside the U.S. could affect your positions, especially assets such as crude oil (CL) ” he said. “Use a stop/loss on your trades because it helps control your risk.”
Since today is witching day, volatility will increase more than usual and some investors will be looking to get out of positions, Mackenzie said.
Trading in smaller positions can minimize losses and lower your risk. Instead of buying three lots in a single order, an investor could purchase one or two lots and watch how the market reacts.
“You’re hitting a single, don’t try to swing for the fence and hit a home run,” he said. “Figure out your average price point and define your downside risk,” he said. “If your goal is $44 and it is trading at $43, place an order right above or below it, but don’t jump in all at once and build out your trade.”
A pullback in the market might occur next week before the Federal Reserve meets, which will lower the amount of volatility, Mackenzie said.
The Chicago Mercantile Exchange’s FedWatch tool shows there is a 12% probability that the Fed will raise interest rates, a decline from 15% on Sept. 14. The odds are based on their 30-Day Fed fund futures prices.
Smooth or Reduce Volatility Over Calendar Time
Futures traders can lower their volatility by investing bit by bit over time which is akin to dollar cost averaging in a 401(k) or IRA, said K.C. Ma, a CFA and director of the Roland George investments program at Stetson University in Deland, Fla. This strategy is more effective in this market because of “maturity effect.”
“Futures volatility tends to increase when approaching maturity, so a natural way to reduce the portfolio volatility is to spread your investment over time,” he said.
Traders can also spread their investments across the same contract of different maturity months at the same time which also lowers volatility and risk.
“A futures contract with longer maturity, by design, has lower volatility than a nearby contract,” he said. “The result is the same in reducing overall volatility, without losing the investment theses of the directional calls of the underlying assets.”
Markets Are Range Bound
When markets begin to move widely, but remain in a range, traders can use daily and longer term charts to determine price action, said Anne-Marie Baiynd, a Detroit-based trader and author.
“When markets become indeterminate or non-trending as they are now, the trading strategies and length of hold time must be adjusted,” she said.
The futures market remains range bound “with sufficient buying pressure showing support levels to recover quickly, but also enough sellers present to prevent an upside breakaway of formation,” Baiynd said.
The market remains in a state with traders waiting “eagerly” for either a breakout or a breakdown to hold, she said.
Baiynd reminds her traders to “identify regions of support and resistance visible on weekly charts and assess the prevailing momentum,” she said. “If momentum is not sloping, the charts will bounce off the floors of support and reject the ceilings of resistance.”
Inexperienced traders often fail to realize that technical trading mechanics need to adjust to the underlying conditions of the charts. Failing to understand can lead the investor to utilize the wrong strategies in the wrong environments.
“As I review my charts each day, this is often one of my primary considerations – have buyers and sellers established a true hierarchy of control,” Baiynd said. “That would mean that if buyers were in control, I would see and upward trend and if sellers were in control, I would see a downward trend.”
Traders should watch the flow of motion, the size of orders at these levels and estimate whether charts are “buying to cover or close their positions (at support), or selling to cover or close their positions (at resistance),” she said.