By Charis Mountis, Head of Dealing at ForexTime Limited
The currency markets have suffered through two major price shocks in as many months after December’s oil price crash, and January’s Swiss Franc surge against the Euro following the Swiss National Bank’s decision to remove the 1.20 CHF per Euro minimum exchange rate. Earthshaking volatility appears to have become the latest trend, but it’s not every trader that knows what to do in this situation. Therefore, it is an opportunity to take a look at trading during market shocks, and see how technical analysis can be best used during periods of high volatility.
During a sudden period of extreme volatility for an asset price, the usual support and resistance levels are most likely to be wiped out, so you might feel that you’re trading in a void because it’s so difficult to pinpoint entry and exit points. A return to the usual price range may take some time, so adapt to the new reality quickly by using a trading tool named the Average True Range (ATR), created by technical analysis innovator J. Welles Wilder.
The ATR tracks the difference between the high point and the low point of an asset price in a given period, and indicates the current level of volatility – high range or low range. Buying or selling signals can come from adding the ATR to the next day’s opening price and buying when the price moves above that level, or subtracting the ATR from the next day’s opening price and selling when the price moves below that level. Adding ‘stop losses’ to the trade is very important and not to be missed as part of your risk management strategy.
Wilder’s observation was that periods of low volatility – as between the Swiss Franc and Euro – would be followed by a period of high volatility. If you use this assumption as a rule for volatility, then the trigger itself doesn’t really matter – whether it’s a central bank’s decision or any other factor, the rule still holds that if there was low volatility in an asset’s price, the inevitable will happen and high volatility will follow.
Another factor to keep in mind is the knock-on effect, in which a sudden rise or fall in one asset has a knock-on effect on another linked asset, the most common example of this being Gold and the US dollar, which have an inverse relationship – when one rises, the other falls. When tracking volatility in one of these assets, it is always worth examining the volatility levels in the other, because more buy or sell signals could be available simply by understanding that a trend in one asset affects the other one.
When trading during volatile periods, it’s essential to remember that your risk management strategy is just as important as your trading strategy, even more so when the risks are higher – as they inevitably will be in periods of market shocks. Understanding your tolerance for risk is key for any trader.If you have low tolerance for risk, it’s better to stay out of these types of markets. Even those who have a high tolerance for risk must still be very careful and manage their exposure. A large market correction can take time to become the new norm, and this time can be used to take opportunities or simply to learn and watch how the market reacts to the new information. As markets tend to be cyclical, there’s always another turn of the wheel on its way.
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