Risk management remains key to stay alive in a volatile market

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Man analyzing financial data and charts on computer screen - Image Depositphotos.com
Man analyzing financial data and charts on computer screen - Image Depositphotos.com

Although the potential gains that seasoned traders can see in highly volatile markets tend to be higher than those seen during more stable scenarios, so are the losses that a portfolio can experience without proper risk management systems in place.

Since the pandemic stroked, volatility has been the name of the game in the financial markets and that reality is not likely to go away any time soon as the world economy struggles to emerge from the outbreak, while governments make their best effort to contain the fallout resulting from lockdowns and other restrictions.

In this context, rather than asking how much you can gain, the actual question should be how protected are you from big losses?

That is where risk management comes into play to limit exposures and cut losses fast and without mercy to prevent a portfolio meltdown.

In the following article, we will explore the most basic risk management strategies and how traders can quickly implement them to hedge their positions against big and unfavorable market fluctuations.

Strategy #1 – Cut your losses short

Stop-loss orders are among the most important tools that traders have to limit how much they lose on a given position by placing sell or buy orders – for short positions – that are triggered once the price slides below a certain threshold.

In this regard, although you want to give volatility some headroom, you should set your stop price at a level that matches a trend reversal signal.

That way, you can quickly anticipate potential shifts in the direction of the individual asset you are trading to get out of the position early before the downtrend fully unfolds.

Strategy #2 – Limit the size of your positions

Even the most experienced traders understand the importance of maintaining their positions in check by limiting the percentage of their exposure to a certain level.

In most cases, a maximum percentage ranging between 2% and 5% per position is recommended for most traders. That means that a trader whose account balance adds up to $10,000 should not commit to a position with an individual value higher than $500.

Strategy #3 – Beware of the impact of positive correlations

Risk management remains key to stay alive in a volatile market

The correlation is a statistical measure used in finance to determine the degree to which a certain asset’s price moves in relation to another.

Although this sounds a bit complex, most trading platforms incorporate a correlation study that you can use to compare how your asset typically behaves compared to other assets in the portfolio.

As a general rule, although during a downturn most correlations go to 1, in a normal scenario your individual assets should have a correlation lower than 0.7 between them.

Strategy #4 – Avoid going against the trend

The market’s trend determines the direction in which asset prices are headed – usually based on the readings obtained from broad-market indexes like the S&P 500 or the Nasdaq 100 in the case of equities.

In volatile markets, an excessive number of positions that go against the market’s trend is not advisable as you may end up losing not because your assumptions are not correct but, instead, as a result of the reluctance of market participants to go against the overall trend.

An old saying explains this more easily: “A rising tide lifts all boats”.

Strategy #5 – Use derivatives for hedging purposes

Derivatives – such as call and put options – can be used to counter the impact of a directional swing in the market.

For example, you can buy put options to hedge against a downturn if your portfolio is mostly long, or you can buy call options if your portfolio inclines toward the bearish side.

In any case, although it is hard to hedge your losses 100%, you can cushion the blow your account balance might receive in case of a trend reversal. The more options you buy, the bigger the hedge.

That said, this strategy has a cost, which in this case is the premium paid for the options.

Strategy #6 – Keep leverage levels in check

In the same way that leverage can expand your profits, it can also play against you when the market moves in the opposite direction of your trade.

Since the risk of reversals grows in volatile markets, you should rely less on leverage unless your risk system is strong enough to tolerate an unfavorable directional blow.

Bottom Line

Volatile markets provide great opportunities for traders to benefit from huge market swings, but that comes at a risk.

If you want to survive today’s highly volatile markets, you should follow some of the recommendations provided above to develop a risk management system that allows you to stay alive even during the most challenging sessions.