Experiencing a weird sense of déjà vu when you look at the markets? Can’t shake that nagging feeling that you have been here before but can’t quite put your finger on it?
Take heart — you’re not alone. In many ways the events of 2011 have followed the 2008 timeline closely of wild stock prices swings and amplified volatility. Let’s just hope that unlike 2008 where the global economy fell into a profound recession, 2012 yet can avoid the same fate.
Most investors will recall vividly the dramatic drop in stock prices during the first quarter of 2008. The uncertainty this sell-off created, in conjunction with rising unemployment and the resulting weaker demand for consumer goods, led to the recession that spared few of the world’s major economies.
In a similar fashion, the Dow likewise fell more than 20% from May to September of this year. Some of those losses since have been recovered, but thanks to the on-going events in the Eurozone, uncertainty once again is hampering market sentiment.
Much of this uncertainty is centered on the continuing saga that is the Greek debt fiasco. The story took on a farcical tone when Prime Minister Papandreou nearly scuppered plans to provide Greece with emergency funding by insisting on a referendum to ratify the deal. Ultimately, Papandreou was forced from office following his actions and a coalition government was formed to pass the austerity legislation required to secure the bailout funds; but even this does not signal the end of the crisis.
If anything, the problems facing Italy will make the Greek experience pale in comparison. This reality ensures that, for investors, the roller-coaster ride is far from over and price volatility is likely to continue.
Investor uncertainty on the rise
The Chicago Board Options Exchange’s Volatility Index — or simply the VIX — measures volatility in the markets based on options contracts contained in the S&P 500. The higher the measured degree of volatility, the greater investor fear and uncertainty. VIX values greater than 30 are considered to be a sign of high volatility.
Leading up to the credit crisis of 2008, the VIX reading was well above 30 with a high surpassing 90 in October 2008. Comparing this to more recent history, the VIX reading during the first part of 2011 was relatively benign, running between 20 and 30 on the scale. However, as of early November, volatility once again appeared to be on the increase and measured above the warning level at 34 before dipping back below 30.
So, what does this mean for currency traders? Tracking the EUR/USD currency pair from January 2007 to the present, it is clear that the exchange rate has endured tremendous volatility.
While this alone is not conclusive evidence of the inevitability of another recession, at the very least it should serve as a warning to traders underscoring the need for enhanced risk mitigation. Here are some ideas for helping to manage increased risk:
1) Reduce leverage to minimize losses
As the risk of volatility increases, one of the first things to consider is the use of leverage. Lowering leverage when volatility spikes can reduce losses, but it also lowers potential gains. Given that the main goal at this time should be capital preservation, most traders should see this as an acceptable trade-off.
2) Allow for wider price swings to avoid margin calls
On a related note, greater volatility also increases the possibility of a margin call. A margin call should be avoided as it results in the closing of open positions thereby locking-in losses. To prevent a margin call during times of greater exchange rate volatility, reduce position size or increase the amount of capital in the trading account.
3) Pay close attention to news impacting exchange rates
The events that took place around the Oct. 26 Eurozone summit illustrate the impact news can have on exchange rates. Immediately prior to the summit, when it appeared a deal to backstop Greece and prevent the spread of debt contagion to other Eurozone members was imminent, the euro received a boost.
However, on the day of the meeting, insiders suggested that an accord likely would not be reached by the end of the day and this sent the euro lower only to rebound later when it was finally announced that an agreement had in fact been achieved. This was all for naught, alas, following Papandreou’s questionable tactic to force a referendum resulting in a dramatic pull-back in the euro as investors turned to the safe haven of the U.S. dollar.
4) Closely monitor all open positions
Keep in mind that an open position is exposed to market price fluctuations. If it is not possible to actively monitor an open position — especially during periods of enhanced volatility — be sure to use automated tools such as stop-loss and take-profit instructions to automatically exit positions.
5) When in doubt, don’t trade
Sometimes the best option is simply not to trade. If it is not possible to sufficiently analyze current events and actively supervise open positions, consider remaining on the sidelines until conditions are more favorable.
It sometimes is easy to forget when you are a trader that you have this option, but many of the most successful traders will tell you that some of their best trades are the ones they didn’t make.
Scott Boyd is a content writer specializing in the financial sector, Boyd has produced educational materials and conducted market analysis for several of Canada’s leading financial institutions. He contributes articles on the global currency markets to the OANDA blog.