If you live in a climate with real winters, you have probably seen a sign like this: "Chains Required, 4WD with Snow Tires OK."
This signage exists for the safety of travelers during winter driving conditions. For those unfamiliar with chains, here is a quick explanation.
Chains can be metal links, mesh, or textured cables that wrap around tires and cut through snow to provide traction. They can mean the difference between reaching your destination slowly and not being able to move at all.
The alternatives without chains are not pleasant. You could find yourself spinning your tires in place, or moving with no ability to stop or turn.
If you have ever put chains on your car, you know the instant feeling of stability they provide. The safety and confidence increase dramatically as your tires grip the snow-packed roads.
I even use this concept when walking my dog. We get snowy and icy weather, and the path I walk has steeper slopes.
That is fine, because I have chains for my shoes. They simply slip over my boots and off I go.
Whether chaining up an 18-wheeler, a compact car, or your feet on a walk, we can mitigate risk and get better traction when conditions get sketchy.
If you have not noticed, there is a blizzard in the markets. The roads are getting worse, and you have probably either slid off the road or seen others slide off the road.
When daily volatility sees entire average daily ranges swing up and down in minutes only to return to the middle, that is the equivalent of spinning tires.
When prices oscillate and then make a weekly move in a single day, you are seeing vehicles drive off the road. Only those who have chained up can safely navigate these extreme conditions.
Our chains for the markets come down to three things: position sizing, assessing liquidity, and adjusted stops and targets based on current volatility.
Position sizing will always be the number one approach to managing risk. If your methods are trading outside of your expectations, you can reduce risk by reducing trade size.
Instead of trading 5 contracts in options, perhaps you trade 2 and cut your exposure by 60%. When you need to place a larger stop, you are not risking more of your portfolio because you have sized down.
Assessing liquidity can be done in multiple ways. The first is to look at the Depth of Market (DOM) and volume.
If you look at the DOM and see that the number of orders waiting to be filled is half of what you normally see, that is a warning.
If you see gaps in the DOM with no orders, that is a warning. If you see a large space between buyers and sellers, that is also a warning.
When intraday volume is light and less than 50% of your average volume for the same time frame, that is a warning too.
Treat this assessment of liquidity like observing the 18-wheelers. When they decide to pull over and stop, they are telling you they do not feel it is safe to drive.
Low liquidity is the big institutions showing they do not feel it is safe to trade in these conditions.
Adjusting stops in volatile conditions can mean either trading larger stops with smaller position sizing or using tight stops for smaller losses.
Larger stops will not get you stopped out as often in volatility. You will not be risking any more due to the reduced position sizing.
With tighter stops, you will see them triggered quickly and the losses will be small. The trades that do go in your favor can still see big gains.
The difficulty with small stops is that you have to be willing to accept a lower probability outcome.
Continuing to execute can be difficult when you experience multiple small losses in a row, even if you know the math is on your side.
Snowstorms do not need to be scary or dangerous. If we assess the risk and prepare our vehicle, we will be fine.
It does not mean we will not feel some nervousness, but we do not need to be afraid. We are prepared.
Get prepared. Whether your trading account is an 18-wheeler, a sedan, a compact car, or simply you walking with shoe chains, you can navigate the inclement weather.
Blake Young
Senior Market Strategist, TheoTrade