We’ve recently had extreme market volatility and the collapse of some major players. What can the individual trader do to survive and thrive in the face of uncertainty?

Paradoxically, chasing certainty is not the best approach for the trader. The trader manages risk rather avoiding it. This means not relying on structured products with “capital guarantees” that depend on the solvency of the counterparty (such as principal protected notes).  Uncertain times means returning to basics and using the tried and trusted vanilla products - stocks, futures, options and forex - and avoiding complex derivatives and products that rely on an investment bank’s guarantee.

At present, I would even stay away from warrants and CFDs because they are reliant on the solvency of the issuer and their ability to be a market maker for pricing.

Vanilla products have their own markets that set prices and provide sufficient liquidity rather than being reliant on investment bank provided prices and market makers.

In recent experience, the most risky products for traders are ones where the risk characteristics are unknown, or pricing cannot be determined by a market.  This was the case in the 1980s with exotic derivatives, and is currently the case with CDOs and similar products.  You must also be aware of the risks of government intervention, particularly in stock and currency markets.  The ban on short-selling stocks is an example of this - you need to gain knowledge on other ways of taking a short position.

This does not mean walking away from trading.  Not trading at all means that you are forgoing the opportunity to benefit from market volatility.  Trading gives you the opportunity to survive outside of the employment system and make a living using a relatively small amount of capital no matter which way markets go.  This independence is always a good thing when the economy is uncertain.

The higher amount of intraday volatility with frequent reversals means a change in trading style.  You either need to be able to adopt a short term range trading strategy and take advantage of the volatility, or alternatively trade the longer term trends.  Trading longer term positions means taking a lot smaller positions than usual in order to be able to take advantage of longer term positions despite the volatility.

In uncertain times, one thing is certain.  Traders who are prepared, can continue to manage risk and who can go back to the basics will be able to continue to reap good returns.

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Tags: bail out, recession, surviving

This entry was posted on Sunday, October 5th, 2008 at 9:23 am and is filed under Trading Basics. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.