We just completed one of the most volatile weeks of trading that markets have ever seen due to he fear of the unknown due to the spread of the coronavirus (COVID-19 ).
Panic has completely gripped the financial markets.
VIX & Market Volatility
The VIX, which is used by traders to gauge market wide volatility, traded above 70 this past week. To place context around this number, the VIX typically trades between 12-20 in most cases. In other words, we are seeing historic extremes in this market right now.
As a result, panic has taken over this market.
I spent all week hearing from traders that were looking to either pull their funds out of the market completely or looking for ways to start recovering from the losses from the last few weeks. Instead of running from the markets, let’s take a look at how we can use the volatility to our advantage in a safe way in the months to come.
Not The First Or The Last For Volatility Extremes
The first thing to establish is the realization this is not going to be the last time volatility reaches an extreme. You can go back in history to see numerous large sell offs.
There was the Tech Bubble back in the late 1990’s and the Financial crisis in 2008 just to name a few.
Bottom line is there will always be risk in the markets. So you need to have a plan in place to navigate the volatile periods when they occur.
Here is a look at 5 Steps that I take in my own trading when navigating through volatile markets.
Step 1: Stay Active With New Trades But Reduce Size
While most traders want to rush to cash when market volatility explodes, I want to take advantage of the opportunity. Trading options allows us to stay active in any market using defined risk trades. When the VIX explodes above 20 I will look to cut my position sizes by 25-50%. For example, if I’m used to risking $1000 per trade I will reduce that number down to $500-$750 per trade.
This allows me to stay active in the markets without feeling the stress of a move going against me. While going to cash might feel safe, missing out on an opportunity to grow the account is not an approach that I want to take.
Step 2: Take A Larger Number Of Smaller Trades
In Step 1 we talked about reducing position size by 25-50%. This will reduce exposure on any individual trade. This will also free up more capital that I can use to take a larger number of smaller positions which will help me get more diversification into my account.
Using a diversified approach in a volatile market can be crucial.
Trading a mix of individual stocks and ETF’s as well as a mix of sectors and price points are all ways of increasing my odds of generating consistent profits regardless of what the market is throwing my way.
Step 3: Trade More Vertical Spreads Instead Of Long Call and Put Options
We are big believers at NetPicks of not falling in love with one options strategy. We hear from so many traders that only want to trade long calls and puts and others that only want to trade vertical spreads.
Trading options gives us access to the most flexible financial products in the world. We can control our risk better in different markets conditions than any other product out there.
The only way to take full advantage of options is to use a variety of different options strategies.
When volatility explodes like we have seen recently, it will result in options becoming very expensive. We are seeing options that would normally trade for $3.00 now trading for over $15.00. This is due to fear being priced into the options by the market makers.
Buying expensive options will make it more difficult to make money.
You need everything to go perfectly in your favor. For example, if you buy a call option after a big market selloff the only way you can make money is if you get a big move higher quickly. The move will need to be big enough to offset the volatility contracting during the move higher.
Instead of buying the expensive options, we would rather use Vertical Spreads.
Selling a Credit Spread when volatility is high will allow us to take advantage of the expensive options. Credit Spreads allow us to put on trades that will give us 5 ways of making money. We are able to make money from a directional move in the stock as well as from time decay working in our favor and from volatility decreasing.
This will increase our probability of success on the trades.
We have a free e-book available that covers how we use the credit spreads in our everyday trading.
Click on the link below to download this free training.
Debit Spreads are also great trades to use when volatility is high because they can reduce the cost of the trades by 30-50% when compared to buying long calls and puts. They are risk defined trades so we know what our max loss is right up front.
They still give us a really nice profit potential from the the trades but with much less risk.
Step 4: Use Options With 20-40 Days Left To Expiration
Traders often make the mistake of trading too aggressively when volatility is high. One way of doing this is to trade more Weekly Options. They do this because the options are much cheaper in many cases and also can produce big profits immediately if the market moves in your favor quickly.
The problem with this approach is they also come with much more risk. The Gamma of a weekly option is much higher meaning they react faster to changes in stock price. If the stock moves against you the trade will lose money much faster.
Instead of using the short term weekly options, we recommend using the options with 20-40 days left to expiration.
Going farther out in time will give your trades more time to work in your favor. This is a more conservative approach that will give you more consistent results long term.
The 20-40 day options will also typically have better liquidity in the options. The higher volume and open interest will help you get better fill prices on your orders.
While they will be more expensive compared to the shorter term options, you will get a higher quality position. Using the vertical spreads like we talked about in Step 3 will help bring the cost of the trades down closer to the price of a weekly option.
Step 5: Only Use Limit Orders
While only using Limit Orders should be followed in all market conditions, it’s especially true in volatile markets.
If you have been trading the last few weeks during the Corona Virus scare, you have seen how wide the bid/ask spreads can be. Markets that are typically .02 wide (difference between the bid and ask prices) were trading $1.50 wide this week.
If you are not careful it can be really easy to get hurt by these wide markets.
We recommend only using limit orders in volatile markets.
We like to place the limit orders close to the mid point between the bid and ask prices. You aren’t guaranteed to get filled at your limit order but it would prevent getting filled at a bad price if you use a market order instead.
While using a market order will get you filled faster, you have no control over your fill price when using them. You are at the mercy of the market at that point and in volatile markets that can get painful quickly.
If you aren’t filled at your limit order price you can always adjust the order higher or lower by a few pennies after a few minutes. You would adjust the limit order higher if placing a buy order or lower if placing a sell order. In doing so you will increase your chances of getting filled on the trade.
Use These Step To Navigate These Markets
Using the 5 steps outline above will help you navigate through volatile markets caused by COVID-19 in a profitable way. Don’t fall trap to the media scare tactics that are trying to get you to the sidelines. Stay patient and keep the risk small. If you do so there are profits to be made in these markets even during a historic move.
***We will be hosting a live webinar training on Monday at 12:00 eastern to talk about how we are handling the volatility due to coronavirus in more detail. This will allow us to walk though the charts and show what we are seeing on our side.
We would love to have you join us. The links to login to the live training are below.