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Price Volatility Vs. Leverage

Chad Butler

When constructing a trading plan, one thing that comes to many traders' minds is volatility. Although many traders trade a particular market to make money on volatility, volatility often comes from erratic price swings, making it difficult (and risky) to trade. The volatility in futures, on the other hand, is due to leverage, not price. This is a difference often overlooked when constructing a trading plan, but it is a critically important consideration when determining the vehicles that a trader chooses to trade. In this article, we'll show you what factors to weigh when determining what market to trade and what instruments to use.

SEE: The Uses And Limits Of Volatility

Price Volatility Vs. Account Volatility

The concept of price volatility versus account volatility is centered around the two core emotions traders must face: fear and greed. These emotions act as checks and balances for the trader. These two emotions must be in balance in order to keep a trader (and his or her portfolio) on track. Typically, we see that traders are attracted to volatile price swings by the possibility of large gains; in other words, they let greed get out of balance with fear.

But huge price swings in any market tend to be anomalies where crowd mentality has taken the price out of line with fundamentals. When this happens, one of two things will occur: either the fundamentals will change to meet the new price, or the price will come back into line with the real fundamentals. Either way, prices typically become erratic when this happens. If you use any type of technical analysis in your trading, you probably already know that this can make reading the market very frustrating. This activity often renders technical analysis very difficult to master.

Price Volatility and Stops
Erratic price swings make the market difficult to analyze and trade. Worse yet, it makes it difficult to calculate and control risk. If a market makes erratic swings up, leaving gaps on the chart, it can just as easily do that on the downside. Therefore, not only is it difficult to get a handle on true market momentum and directions, the risk that the market will gap down past your stop is very high.

This is an important point about stops. A stop becomes a market order when the market trades at or through your price. For example, on the sell side, a stop to sell gold at $650 will be executed at the next possible order when the market trades at or below $650. If the next possible trade from $650 is $649.90, you don't have much to worry about. But what happens when the market trades at $650.10 and then gaps lower to $645? That could be a problem for some accounts.

SEE: A Logical Method Of Stop Placement

What Goes up, Must Come Down
Volatile markets can be dangerous to trade from a risk management perspective, but they also can be difficult to trade from a directional standpoint. There are some clichés to keep in mind. One that is especially important for trading the long side is that markets tend to come down faster than they go up. As an example, consider silver futures during 2006.

Silver took about four and a half months in 2006 (from Jan. 25, 2006, to May 11, 2006) to make the move from $9.50 per ounce to a high of $15.20. Following that high, it only took one month and four days for the move to retreat, making a low of $9.45 on June 14, 2006. Stocks, futures and currencies are all susceptible to this principle.

How Risky Is Futures Trading?
If price volatility is to be avoided, what opportunity is there to make money? In many cases, appropriately controlled leverage may be a better approach than being involved in volatile (and erratic) markets. Although many traders believe futures to be high risk, the price movement in the liquid futures markets is far less volatile than in what are widely considered to be safer investments. By using leverage, a trader can achieve the returns he or she is seeking, with less price volatility.

It is widely accepted that commodity prices, when compared to stocks on a non-leveraged basis, are far less volatile. Instead of the volatility coming from price swings, the volatility would be based on the amount of leverage employed. It is important to note that, while there are minimum margin requirements in futures, there are no maximums. To reduce leverage and account volatility, apply more capital to the margin posted. This will not only reduce return on invested capital, but it will also reduce risk.

What Markets Should I Trade?
Choosing the right market in which to trade involves weighing many factors. Quite often, beginner traders wonder about learning to trade certain markets. Based on their questions, it is clear that their first decision is often to choose a market to trade, rather than other factors like how much capital to work with, or what the risk factors might be. However, decisions about what market to trade should actually come at the end of the planning process.

A primary reason for this is that the swings of the market you are trading must fit not only your profit objectives, but your risk tolerance as well. If you are looking to trade predetermined markets without a solid reason as to why, you need to throw that idea out the window and begin your plan from scratch. (It is possible that you may end up with the same market at the end, but you need to substantiate your reason to trade the markets you are trading.)

Begin by determining the amount of risk capital you have available. You will need to determine what type of trading suits not only your personality, but also the time you have available to trade. Make sure to decide on the type of profits you are targeting and the amount of risk you are willing to take. Only then will you be ready to develop, build and/or fine-tune your trading plan. Only from that point is it logical to begin analyzing markets.

The Bottom Line
The markets you choose to trade must fit all of the above factors. The potential swings in the market must fit your trading time horizon and your risk parameters. Your profit objective must reasonably fit the market as well. From there, adjustments can be made to your leverage to increase the potential returns on invested margin. Just remember that with increased leverage comes increased risk.

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