How to best manage volatility and risk when trading
For some traders, market turmoil is very disturbing. They have to face negative emotions and responses that are challenging to deal with.
But it’s a fact – markets can’t always go up. They are sometimes random and volatile. There will always be periods of uncertainty you need to be ready to face and take advantage of to be a successful trader over time.
As the popular American investor and mutual fund manager Peter Lynch declared, “People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game”.
So, let’s have a look at some of the best ways you can manage both volatility and risk to protect your capital and profit from such market conditions.
Accept that trading is risky
The first thing to do to be able to manage volatile and risky markets is to understand and accept that trading is a risky activity that might lead to a loss of money – maybe temporarily, maybe permanently. That’s why you should always trade with money you can afford to lose.
Focus on financial assets that fit your trader profile
By focusing on financial assets that are a good fit for your trader profile, as well as your goals, your time horizon, your individual financial situation, and your risk tolerance, you will be able to better manage your risk capacity and select assets that correspond to your needs.
Take into account global market sentiment
Being able to determine what mood dominates the market will definitely help you have a better grasp of overall market conditions, which will, in turn, allow you to better protect your positions if needed and/or take advantage of changes in market sentiment.
There are a range of different tools and indicators you can use to measure market sentiment, such as trading volume, Commitment of Traders (COT), VIX, high/low ratio, and put/call ratio.
Always have a look at an economic calendar
Throughout the year there are a variety of economic reports that are released which can lead to an increase in volatility, depending on the figures released and what the market’s prior expectations on the report were. That’s why you need to always consider the release of important economic statistics, central banks’ meetings, or speeches when trading.
For that, you can use a financial and economic calendar. You can also watch a channel delivering business and market news to follow the releases’ impact on the markets in real-time. If you trade during the earning season, you should also take a look at an earnings calendar. It’s also useful to be aware of days off and holidays, as they can impact market liquidity and activity.
Diversify your portfolio
One of the most popular beliefs about reducing overall portfolio risk is modern portfolio theory from Harry Markowitz which relies on diversification as a way to mitigate portfolio risk.
If you diversify your portfolio well enough, you might be able to reduce risk by investing in different products, markets, assets, countries, sectors, and currencies. For that, you should also take into consideration market and asset correlations, meaning that you should focus on investments with low or negative correlation.
Always follow your trading plan
If markets start to fall, you have to remain calm and avoid letting your emotions take over. Do not sell everything in a panic. You need to remember that you have a trading plan to follow and that you have financial and trading goals.
Also, remember to always take into consideration your time horizon. Market turmoil and uncertainty might also bring opportunities you can take advantage of by investing in assets you might have wanted to add to your portfolio but were too expensive.
Respect your money and risk management rules
To better manage risk when trading, you need to integrate money and risk management rules into your trading plan. These rules should depend on the time horizon of your investments, your goals, your strategy, and above all, your risk appetite.
Of course, there are general rules you can rely on, like never over-leverage your trading positions, never put all your capital in a single position, always set up stop-loss orders when opening a position, use a risk/reward of at least 1:3, adapt the size of your position to your level of leverage and market conditions, determine the maximum losses you’re willing to bear per day, week, or month.
Keep your emotions under control
When trading, it’s essential that you learn to control your emotions, so then they don’t control you and don’t affect your trading process. There is nothing worse than emotional trading and investing, especially in the ever-changing tides of financial markets, as it often leads to poor decision-making.
To best manage your emotions, you first need to identify and recognize the ones that have the greatest impact on you, so then you can avoid them taking control. If it helps, you can keep a mood/emotion journal.
Adopt the right mindset
As we said at the beginning of this article, trading is risky. Most of the time, you are your own worst enemy, as there are many different things that can alter your mindset and negatively influence your trading. That’s why you need to build a strong and positive trading mentality when trading.
To adopt a positive trading mindset, you need to accept that you will be wrong and that you will lose money at some point. But that’s ok. Knowing and accepting that will help you adopt the right trading mindset and make all the difference between failure and success over time.
Review your trading process from time to time
When market conditions change, it might be a good opportunity for you to review your trading process in order to make necessary adjustments to better profit from the volatility or to better protect your positions.
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