When a big news event happens; or even perhaps a news event driven by an economic catalyst, like the 2008 Financial Collapse, markets can attempt to price in the newest data so fast that prices move at breakneck speeds. For the poor investors that are in long positions in mutual funds, the hope of stemming the bleeding before market close doesn't exist. They have to wait and watch the devastation until the end of the trading day so that they redeem out of their mutual funds.
But to the trader that can take a short position just as quickly as 'hitting the bid,' these 'panic' periods present quite a bit of opportunity. Prices are moving fast and pips can stack up quickly ? if you are on the right side of the trade. The big question is if this is something that fits in your trading plan?
What type of trader are you?
By many accounts ? fundamentals and news events create price changes, thereby ? fundamentals dictate what prices will do. Technical analysis on the other hand, analyzes past price movements, showing us what prices have done. And sometimes, what price has done in the past can help us build a game plan for the future; looking to those fundamental catalysts to create big price movements (the hybrid fundamental-technical trader).
The alternative approach is the trader that analyzes those same past events, looking to avoid those fundamental catalysts, hoping that the technical levels from the past hold true (the technical-range trader).
That's really all there is. A pure fundamentals trader wouldn't be looking at charts at all, and a 'technical-breakout/trend' trader would really be, in many ways, looking to fundamentals to continue substantiation of those trending/breakout conditions, so they wouldn't really be a 'pure technical' trader.
Considering the fact that 'panic' markets can create rapid price movements in a short period of time, which can just as easily work against the trader as it can for them, it behooves one to know as much about their risk profile before wagering their hard-earned capital.
So, if you consider yourself a 'pure technical' trader, and have no interest whatsoever in following or keeping up with the news ? I advise you to attempt to avoid panic markets. This can often be done by setting stops at major levels of support (or resistance in the case of short positions) so that when we do get those big breakouts ? they don't work against you too heavily.
For all those that dare to tread in fast markets ? read on; and we will share with you some ways that experienced traders approach these volatile scenarios.
How to Trade Fast Markets
The same question was broached in the article 'How to Trade Forex Majors Like the Euro during Active Hours,' and the recommendation to trade breakout strategies could not be more on point.
As David shows in the article, increased activity often means larger and potentially more erratic price movements. And because these movements can be more erratic, it can greatly affect the trader's ability to forecast price changes. The chart below, taken from the aforementioned article, shows how widely price swings can magnify on EURUSD during the London and the London/US overlap session (often considered the most 'active' period in the FX market).
Now if we consider that panic markets often have an external stimuli; whether it be a natural disaster like what was seen in Japan in 2011, or a man-made disaster like what was seen at Bear Sterns and Lehman Brothers in 2008 ? we have to know the market movements can be even more exaggerated, meaning price movements can become even more magnified, and forecasting can become even more difficult.
Why trade breakouts to address panic?
Because price movements can become greatly magnified while also becoming more erratic is the reason why trading breakouts is the best prescription for handling volatility. If we happen to be on the right side of the movement, price can trend for a continued period of time, giving us far greater potential profit targets if we are right. If we're on the wrong side of the movement (which will probably happen more than half of the time), then we can cut our losses early before the pair continues against us in a move that could potentially drain our accounts.
A critical aspect of trading breakouts is the necessity of strong risk-reward ratios, such as the trader risking 20 pips, but looking for 100 pips if correct. This could be expressed as a 1-to-5 risk-to-reward ratio (20 pips to the stop-loss order ? 100 pips to the profit target = 1:5 risk-to-reward).
This is what can allow rampant volatility to actually work in your favor.
With a risk-reward ratio so aggressively on the trader's side, one would need to be right only 2 out of 5 times to gleam a net profit. If a trader was right 40% of the time with a 1-to-5 risk-to-reward ratio, they could be looking at a handsome profit (2 winning trades at 100 pips each = 200 pips won, 3 losing trades at 20 pips each = 60 pips lost, net profit of 140 pips (200-60) not including commissions, slippage, etc).
But what if the trader above was only right on one out of five trades? Well, they are still looking at a net profit (once again, not including spreads, slippage, etc). One winning trade at 100 pips only gives up 80 to 4 losers at 20 pips each, leaving a net profit of 20 pips; and that is with a winning ratio of 20%.
How to Trade Breakouts
An easy way of looking at breakout strategies is to simply think of ranges ? and then reverse it.
While range-traders look to buy support and sell resistance, breakout traders await breaks of resistance to buy (in anticipation of price continuing to rise now that resistance is broken) and looking to sell when support is breached (once again, looking for price to continue heading lower).
There are numerous ways of identifying support and resistance levels to be used for breakout strategies. Some traders don't even use indicators, electing, instead, to simply analyze and build their strategies off of price, and price action. Some traders rather use strategies based on indicators like Price Channels to point out these support and resistance levels. Many of the various Pivot Point offerings or Fibonacci studies can help in this same regard as well.
Whatever the mechanism, it is important to realize that complete elimination of false breakouts is totally impossible. What often makes or breaks a breakout strategy is money, risk, and trade management.
This is a hazard sport, as it can be a regular occurrence for price to break support (or resistance) briefly enough to trigger our, only to pop back into its prior range. This can be frustrating for breakout traders, and has even earned the title of the 'false breakout.'
This topic was explored in greater detail by Walker England in the article 'Can False Breakouts be Prevented?'
Not to spoil the article, which you should absolutely read, but the answer to the question is 'No.' False breakouts, unfortunately, cannot be prevented.
To the trader looking to be more conservative, additional 'wiggle room' can be given to the entry in an effort to attempt to decrease the chances of caught by a false breakout.
But preventing false breakouts is impossible due to the simple fact that no trader in the world knows what will happen next. So when trading panic markets, protect your trade, protect your account, and trade your plan.
--- Written by James B. Stanley
The views expressed are not FNArena's (see our disclaimer).
For real time news and analysis, please visit http://www.dailyfx.com/real_time_news
DailyFX provides forex news on the economic reports and political events that influence the currency market. Learn currency trading with a free practice account and charts from FXCM.
Forex Capital Markets is headquartered at Financial Square 32 Old Slip, 10th Floor, New York, NY 10005 USA.
Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before you decide to trade the foreign exchange products offered by Forex Capital Markets, LLC, Forex Capital Markets Limited, inclusive of all EU branches, FXCM Asia Limited, or FXCM Australia Limited, any affiliates of aforementioned firms, or other firms under the FXCM group of companies [collectively "FXCM Group"] you should carefully consider your objectives, financial situation, needs and level of experience. If you decide to trade foreign exchange products offered by FXCM Australia Limited you must read and understand the Financial Services Guide and the Product Disclosure Statement. FXCM Group may provide general market information and commentary which is not intended to be investment advice and the content of this email must not be construed as personal advice. By trading, you could sustain a total loss of your deposited funds and therefore, you should not speculate with capital that you cannot afford to lose. You should be aware of all the risks associated with trading in foreign exchange products. Foreign exchange products are only suitable for those customers who fully understand the market risk. FXCM recommends you seek advice from a separate financial advisor.
FXCM Group assumes no liability for errors, inaccuracies or omissions in these materials and does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. FXCM Group shall not be liable for any special, indirect, incidental, or consequential damages, including without limitation losses, lost revenues, or lost profits that may result from these materials. This email is not a solicitation to buy or sell currency. All information contained in this e-mail is strictly confidential and is only intended for use by the recipient. All e-mail sent to or from this address will be received by the FXCM corporate e-mail system and is subject to archival and review by someone other than the recipient."
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
FN Arena is building the future of financial news reporting at www.fnarena.com . Our daily news reports can be trialed at no cost and with no obligations. Simply sign up and get a feel for what we are trying to achieve.
Subscribers and trialists should read our terms and conditions, available on the website.
All material published by FN Arena is the copyright of the publisher, unless otherwise stated. Reproduction in whole or in part is not permitted without written permission of the publisher.