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How to Trade Volatility
I used to do a very popular presentation called “Trade like an Insurance Company” in which I demonstrated the very many lessons that the insurance business can teach us. The three principal ideas that I still think are of inordinate value to traders are risk handicapping, risk capitation and the law of large numbers. Any trader who applies those concepts to his own book will generally improve his performance.
There is however one glaring flaw with the insurance metaphor. When we think of insurable risk we generally look at very stable actuarial products such as life, auto and house insurance. Within those domains we have very robust and highly predictable data that allows insurance companies to price risk with great precision and profitability.
There is however, one segment of the insurance industry that always get walloped for big losses every few years -- property and casualty underwriters. In fact even the great Warren Buffett suffered some ugly losses a few years back when hurricanes wreaked havoc across the seacoast of US. The reason why property and casualty is so hard to handicap is because while human beings are pretty predictable, mother nature is not.
I bring this up because capital markets which for the most part exhibit the predictability of human behavior can sometimes morph into mother nature and unleash volatility storms that can batter and destroy your capital faster than Hurricane Katrina.
This week was a good example of just such vicious price moves in action. At BK we were fortunate to be on the right side of the move and the only complaint I had was that I could not move my trailing stops fast enough. But what if the situation was reversed? What if the trades went against us?
The only way to survive the huge volatility moves of the market is to either trade small or always hold stops. This Wednesday’s wild ride was a great example of how most traders lose money. Generally, all the hard luck stories of the market are never a function of many bad trading decisions, but rather the result of one trade gone horribly wrong. Understand that leveraged products are designed for the margin call -- which is effectively a forced stop out.
So if you trade on leverage the only way to avoid the volatility stop out is to run very tight stops yourself. You won’t avoid losing money, but this will prevent you from losing it all.
Alternatively, you can take the power away from the market and just trade on no or very low leverage. That is my preferred method of surviving and even thriving in the volatility storms. A low leverage position in USD/JPY which was miserably under water Wednesday morning was back in profit by Friday afternoon IF you had the capital to hold on. And the only way to hold through the storm was to trade low leverage.
Its a lesson worth remembering always, but especially on weeks like the one we just had.