Friday, 8 August 2014

How to Take Advantage of Volatile Markets ?

Volatility is your friend. We talked about why this is case in the previous article. The short answer is that high volatility provides more trading opportunities. High volatility means that markets move up and down a lot. As a result, the more volatile markets are, the more money we can make. 

It turns out there is another more subtle reason why volatility works in your favor. To understand what I'm talking about, let's examine a simple example. Imagine you are playing your favorite card game (bridge, rummy, poker, etc.) You bet money on the game and are playing against others who understand the game well. 

If you and the others are playing, you may be equally likely to win or lose. But suppose all of a sudden, the others start playing irrationally. They abandon their strategies and just play without any logic. What will happen then? 

What happens is that you'll win the game. If the other players play poorly, you can take advantage and win against them. 

How does this relate to market volatility? Think about what happens when markets get very volatile. People start to panic. They may sell their investments at any cost just to get out. In fact, the main reason volatility occurs is that investors try to get out as quickly as possible. 

Do you see the parallel here with the card game? When markets are volatile, investors are behaving less rationally. They are thinking more with their emotions. They want to get out because they do not like the higher risk. Risk aversion goes up when volatility goes up, and many investors get out of the market when it gets too risky. 

When some investors are not behaving rationally, this works to your advantage as a trader. Just like you can beat card players that play irrationally, you can beat other traders and investors that behave irrationally. 

There is one simple rule you need to follow to take advantage of other irrational players. Stay calm and play rationally. That is it. When everyone else is in panic mode due to some crisis, you need to stay calm. When everyone else is euphoric due to a positive news event, you need to stay calm. 

Doing this is easier said than done. It is generally easy to stay calm if you are making profits. But what happens when you make losses? This is where your mental strength gets tested. The reason other investors behave irrationally is typically because they have incurred large losses. This makes them want to get out of the market at any cost. 

To avoid this problem, you need to stay calm when you lose money. And you will lose money on some trades. I sometimes lose money, and so do all other traders. Even if you incur large losses, you must stay calm and carry on. 

You need to think of gains and losses as just numbers on a screen. When markets move up or down, think of them as just numbers on a screen. Don't attach any emotional value to these numbers. Nothing good will come of it.

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