Adjusting To The New Reality In Oil Markets

After a period of quite literally unprecedented volatility in oil markets, things seem to have calmed down a bit over the last month or so. July WTI futures (CLN20) have recovered nicely from the $6.50 low and are now trading back in the thirties, but remember, upward movement is still volatility. If it weren't for the dramatic collapse, would anyone consider a 300%+ jump in a month to be a "quiet" market?

Of course not. So, while it may seem like the worst is behind us, it is still a good time to consider the adjustments that traders should make when dealing with volatility.

In my nearly twenty years in dealing rooms around the world, I traded through multiple booms and busts and more black Mondays, Wednesdays and Fridays than I can remember. I survived because early on I was surrounded by veterans who had already seen it all, and who gave advice freely on running positions in volatile markets.

That advice started with the most basic thing of all…adjust to volatility.

Most traders, both institutional and individual, find a strategy and style that works for them and then stick to it. That is generally a good thing, but when the nature of the market you are trading in changes it often negates that strategy. For example, I am, by training and nature, drawn to contrarian trades, always looking to "buy low and sell high". As volatility increases though, pivot points, whether based on fundamental or technical analysis, are routinely ignored. As big swings become more commonplace, therefore, I switch to more of a momentum-driven style, happy to "buy high and sell higher".

That makes sense from a logical perspective as, by definition, moves are exaggerated in volatile markets. But it also has another advantage for a trader.

"Going with the flow" enables you to set closer stop-loss orders than going bottom fishing.

If you are trying to pick the top or bottom of a move, you have to leave a lot of room for the trend to continue beyond its logical endpoint when things are flying around, while still keeping potential losses under control. That means wide stops, resulting in bigger losses when you are wrong, and smaller positions and therefore smaller profits when you are right.

If your assumption is that a move will continue, then even a quite small reversal proves that assumption wrong. You don't need to set your stops a long way away from your entry point, so you can take closer to normal-sized positions. The effect of all that is to decrease potential losses and increase potential profits, and you don't have to be a genius trader to know that is a good thing!

Another change I was taught to make when dealing with volatility is to rely more on trailing stops, rather than just setting targets for winning trades. Again, that has to do with the tendency for moves to continue way past their logical end when liquidity is low, and volatility is high. Trailing stops mean that you will never hit the high of a move up, but they do allow you to benefit from things like the nearly 150%, one-week gain in crude that started on April 28^th.

It is important to understand that whatever you do, volatility still means increased risk. There will be times when the market gaps and fills on even quite tight stop-loss orders are a long way away from where you might usually expect. In that scenario, you will take a big loss even if you were suitably cautious. If you factor that increased risk into your position size, however, trade with momentum, and allow room for profits to run, there are also some big opportunities in volatile markets.