Trading in the eye of the storm can be risky, but since volatility can pop up like a summer squall, traders need a plan to navigate stormy markets.
For a ship to survive massive waves that threaten to engulf the ship or tip it over, it takes an experienced captain to juggle countless factors to form the right decision at the right time.
Weather patterns, gravity and underwater currents all affect the oceans’ tides. They serve as good indicators, but even with the best technology to interpret them, it still takes a combination of skill and will to navigate them safely.
The same is true for trading the markets.
Volatility moves back and forth between two extremes, which can rock the confidence of your trading decisions as the markets get thrown into a tailspin. The unexpected shock and awe from war, corporate scandal, accounting irregularities, investor sentiment, unexpected earnings reports and any of a dozen other variables can throw the market into a nosedive and take you down with it.
This becomes a sign to form a strategy that takes volatility into account to profit from it rather than become a victim to it. But, before you do that, you must fully understand the cause and effect from the market’s turbulent waters, so that you can ride those waves instead of getting taken down by them.
Fast-moving price action can scare most traders out of the market due to perceived higher risk. Commonly, traders will sit it out until things cool off and then re-enter the market when things are perceived to be safer.
This aversion to volatility is understandable to the average trader but to the pro, achieving superior returns requires acting independently against the crowd.
But, that doesn’t mean you should jump in with both feet without knowing how the depth of the side of the pool you’re going to play in. You still must know how to swim and navigate those waters if you’re going to come out the other side as a winner.
Across the market’s timeframes, price trends begin to crash into each other causing huge spikes in daily trading ranges shaking out the weaker players and forcing big institutions to hedge.
Price becomes more sensitive to bad news as the media cycle pumps out negative reports on the economy or financial markets, causing price to become more erratic.
But, looking closer can reveal trade opportunities just underneath the turbulent surface.
To do that, you just need a few simple tools to look past the market’s raging front to find the right places to pick your entries and exits.
The Tempest Trade Setup
When trading in the middle of a volatile storm, it helps to use a method based on simplicity while considering the strengths of the market at hand. Volatile markets must be traded differently than neutral markets, such as markets that are range-bound with no direction. This requires flexibility on your part and knowing your individual risk tolerance.
To help, the Tempest Trade Setup will help you navigate volatile markets without being swept up in their currents.
Tempest Trade Setup Rules:
Use an 18-period Moving Average Regression Line (MARL).
In bullish markets, use Regression Channels to connect two successive price higher highs, or
In bearish markets, use Regression Channels to connect two successive price lower lows.
Set your readings to extend the price lines from the Regression Channels.
Longs are triggered when price hits a new high then trades near the bottom of the Regression Channel followed by an entry above the 18-period MARL.
Shorts are triggered when price hits a new low, then trades near the top of the Regression Channel followed by an entry below the 18-period MARL.
Netflix (NFLX) provides an example of the Tempest Trade Setup in August 2017 (see “Reversion to trend,” left). NFLX traded higher on a huge gap signaling rising volatility in mid-2017. The bullish trend began reverting to its mean during a period of weeks as revealed from the Regression Channel from July 27, 2017 to Aug. 10, 2017. As price traded below the lower line, the Tempest Trade Setup was signaled. Later, on Aug. 16, 2017, price traded back up through the 18-period MARL triggering an entry at $169.98.
It is important to remember that if the 18-period MARL trades outside the upper or lower Regression Channel band, then the setup is canceled. You can readjust the Regression Channel to the new price high or low to compensate for future setups.
The 18-period MARL is designed to tell you where price should be while acting as a trend filter. The Regression Channel creates a visual of the price range while the 18-period MARL reveals where price should be, but typically will swing back in the direction of the dominant trend.
Use regression moving averages to track price movement and draw channels from high to low, depending on the time frame, and then extend the price lines to create a visual. When price and the regression moving average break the channel, traders should wait until two new price points create the foundation for a new channel.
Volatility & Irrationality
It is human nature to strive to secure some type of certainty for a particular outcome. This aspect of human nature sets up a conflict between certainty and the unpredictability of the markets.
At any given time, there are a few forces at work that create waves of panic and greed. War, surprise earnings, unexpected political policies, change of corporate leadership, economic changes, changes in interest rates and lawsuits are all examples of external events that you can’t control or are even aware of at any given time. But, these types of events can spark extreme emotional maelstroms of fear and greed that can disrupt price action and current trends, or push them further in a given direction. It also can create higher volatility, expanding trading ranges to extremes, which can be multiplied by the velocity of its movement in a given timeframe.
Like dominoes falling, you can see volatility picking up speed as fears begin to rise regarding the loss of and/or missing out on potential profits. This creates a herd effect where traders make more emotional decisions based on price movement with price rising and falling due to the supply and demand generated by the heavy trade orders.
With volatility, you can choose to remain on the sidelines or get involved in the action. If you stay on the sidelines, you are safe from getting caught by an unexpected move, but you may also miss out on one of those huge price moves that volatile markets are famous for.
In early 2017, General Electric’s (GE) stock peaked and then began to trade downwards. On Feb. 28, 2017, GE stock experienced a series of lower lows that allowed traders to start tracking its Regression Channel from those points (see “Lighting a short,” right). However, as the downward trend continued, both price and the 18-period MARL kept trading beyond the upper boundaries. This would cause you to keep readjusting the Regression Channel for an accurate visual of the setup. In early May of 2017, price traded below the upper channel line then traded back up to it before crossing below the 18-period MARL, signaling a short entry at $28.70.
Good trading is based on a foundation of healthy contrarianism. Fast-moving markets offer enormous opportunity, but there is the risk of getting swept up in the same emotional traps of fear and greed as everyone else. However, taking a moment to look in the opposite direction while armed with a few basic facts can help you make the right decision at the right time.
When markets are experiencing high volatility, extreme price points are caused by an imbalance of buying and selling orders. Price can be pushed too far, too fast because one side is more committed than the other. At times, there can be total buy orders with no sell orders and vice versa with volatility steadily rising. But, spikes in volatility are followed by a reversion to the mean where price will return to its median price point. Like a rubber band that gets stretched too far before snapping back to its original shape, price can snap back in the opposite direction.
It may cause the trend to reverse direction or it may just be a temporary condition that occurs before the trend resumes. It is in these moments of trend resumption where the trading opportunities live.
The Tempest Trade Setup is a good method in any market or timeframe. However, it’s important to keep in mind that entering a volatile market is going to take more than just a good trade setup or method. The ability to manage the trade while being detached from the end result and maintaining the ability to go from trade to trade is fundamental to your success. And, even more importantly, the ability to know what your risk level is and how to manage that risk is even greater.
The Tempest Trade Setup is just a vehicle to get you to your destination, but your ability to reach that destination can be mitigated by your ability to operate in it. There is more to just turning the key and putting the car in drive. You must be able to adapt to changing weather conditions. Storms often hit in waves; a wave hits, wanes and then reemerges.
Traders need to be committed to the long-term results, not the short-term disappointments. While it’s wise advice to avoid volatile markets, volatility doesn’t always announce itself, so traders need to assume it can hit at any time and have a plan to address it. This will keep you level-headed and focused in volatile markets and in full control of the tools that will help you reach your trading goals.