How to trade volatile markets

Recently we have seen a surge of commodity-led volatility in the equity markets.

A look at internet stock forums shows how pure speculators are wholly immersed in this market, with much talk surrounding the violent swings in share prices for small, highly leveraged oil explorers, whose business model depends on a high oil price.

Esther Armstrong asks: How long is the market slump set to last?, with analysts split over when the market will hit a full bear trend.

Certainly investing in these companies is not for the fainthearted, but contracts for difference (CFDs) and spread betting can protect your underlying portfolio by placing a short position to profit from a price fall if you fear the worst.

When US Federal Reserve chairman Ben Bernanke expressed concern over the sluggish growth of the US economy, giving no indication there would be a further round of quantitative easing to help aid the recovery, oil prices reacted badly and increased downward pressure on equities globally.

The following day, markets anticipated that OPEC would increase supply by 50,000 barrels per day, adding further downward pressure. When this didn't come to pass we saw an oil price spike. Throw in global economic uncertainty and volatility in currency markets and we can expect wild swings in commodities to continue in the long term.

Working in the retail derivatives side of the industry at Interactive Investor, my client base is a combination of traditional, long-only investors looking to hedge some short-term risk by running short positions against their underlying holdings; and pure speculators looking to make short-term trades using spread betting and CFDs.

Playing on volatility 

Short-term speculators love volatility and in the current climate, trading volumes are on the rise. Most investors would run a mile when thinking of dipping their toe into this kind of trading, but through sticking to some basic rules many can see the benefits; and indeed the potential profits available.

A basic understanding of technical analysis and risk-management strategies is key to successful timing of trades within such a market. Identifying a trend - whether it be short, medium, or long term - is a fairly basic tool which should be in the arsenal of even the most novice investor.

From the trend we can identify levels of support and resistance. A support level is an area lower than the current price where the buying is strong enough to overcome the selling pressure - creating a trough or low. A resistance level is an area higher than the current price where the selling is strong enough to overcome the buying pressure - creating a peak or high.

The idea is to place your trade around the levels of support and resistance. So at a level of support, you buy and at resistance you sell. Many investors also set up for a breakout at the resistance level - but let's not overconfuse the issue.

Generally, it is good practise to follow the trend. If you don't, then you're betting against the market.

So in an upward trend, plan to execute your entry into the market at a level of support within the trend and exit before the level of resistance is reached. This is generally termed as swing trading and is a commonly used method for trading volatility.

We can attempt to plot these points in a line. For example, in an upward trend we will identify a series of higher highs and higher lows. As a general rule of thumb technical analysts will identify a trend line using two points to identify and three to confirm.

When you have identified the trend it's time to set up your trade. First you need to establish how much cash you are willing to risk on a trade. It is usually good practise when starting out to use what we call the 2% rule: risk only 2% of your trading capital on one trade. So if you have a balance of £1,000 in your trading account, risk £20.

There is a common misconception that day trading is all 'clickity click', with traders executing deal after deal after deal. The most successful day traders I know are patient and clinical in their trade execution and most certainly do not overtrade. Be patient. Set up an order to enter the market at the pre-determined level you have identified and wait.

When using support and resistance levels you should have more confidence in the price but always use a stop loss if, well, you call it wrong. With CFD trading, for example, if you buy 100 CFDs of a particular share, set your stop loss 20 pence away from your entry price, as governed by the 2% rule.

All in all, trading should not be overcomplicated. A good deal of patience and a handle on the basics is all that is necessary.

Mike McCudden is head of retail derivatives at Interactive Investor, and this article appears in the August edition of our sister publication Money Observer.