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How to formulate a trading strategy for volatile markets?

05 Jan 2023

Ask anybody about their trading strategy in volatile markets and their immediate response will be to point out to the India VIX that has been consistently falling over the last 7 months. In fact, since the election of Donald Trump as president of the United States in early November 2016, the volatility in Indian markets as well as across global markets has been on a clear downtrend. Volatility Index (VIX) is also known as the Fear Index and captures the extent of fear in the market. Normally a high level of VIX is a sign of fear in the market and tends to be followed by a correction in the markets. But they, why worry about such things when the VIX has literally halved in the last 7 months and is almost threatening to go into single-digit territory?

Source: NSE
But, that is precisely the point. When VIX goes down sharply and stays low at that level for too long, it incentivizes a lot of traders and investors to take on inordinate risks in the market. Most traders almost tend to equate equities with a low risk asset class, which is obviously not the case. That is why normally, prolonged periods of low VIX tend to be followed by a sharp spurt in volatility. That is exactly the reason traders and investors need to start preparing themselves with a strategy on how to handle volatility in markets.
1.  In a long-term bull market, cash is king in volatile times..
Assuming that the Indian market is in the midst of a prolonged uptrend, the volatility should be used as an opportunity to add to your positions in quality stocks. How do you keep your money invested in near-money assets or at least in less volatile sectors is the challenge. One of the biggest challenges in a sudden market correction is not having sufficient liquidity at your disposal to capitalize on the opportunities that a correction will give you. Ensure that you have enough cash or at least are able to liquidate at short notice to make the best of lower prices. After all, when the tide comes it takes the good stocks down along with the bad.
2.  There is no point in trying to time the market, but do use benchmarks
There is an old adage that "Time always works better than timing in the equity markets". If you are invested in quality stocks, you are bound to earn superior returns over the longer period. But then how do you generate the alpha. That is where volatility gives you an opportunity. Of course, trying to catch the bottom and selling out at the top are great on paper but almost impossible to do in reality. The best you can do is to use benchmarks. For example, look at previous cases of such volatile markets and check how much the P/E of the index has corrected. That will give you a fair idea as to when and how much you should enter the market and buy. That not only works but gives you the additional alpha over and above your buy-and-hold strategy.
3.  Keep investing regularly; that is safer and simpler
If you do not want to get into the rigmarole of low P/E ratios and high P/E ratios, the best way out for you is to focus on regular and periodic investing. You can call it an SIP or any other name; but the moral of the story is that a phased approach works best in a volatile scenario. For example, between 2007 and 2017; the index would have hardly given a return of 4-5% annualized in absolute compounded terms. But during this entire volatile period if you had opted for a SIP on an equity fund, your annualized returns would have been around 14-15%. Needless to say, you have achieved this through all the volatility without too much of an effort.
4.  If you are a trader, stick to your trading plan and your risk tolerance
The most important rule for a trader in volatile markets is to stick to the trading plan. Volatile markets are not the time to take on more risk but to take on lesser risk. Remember, the chances of hitting a stop loss are much more in volatile markets and hence you need to trade with stricter stop losses and lower risk tolerance. Also, in volatile markets you must rely more on limit orders rather than on market orders. 
5.  Preserving your capital is the top priority
Ensure that your losses do not wipe away too much of your capital, especially if you are a trader. Typically, when you are in the midst of a long term uptrend in the markets, then volatility does not last for too long. However, if you lose too much capital then that may restrict your trading capacity once the normalcy returns to the markets. Keeping a strict max-loss limit and don’t ever risk your capital beyond that. In fact, during volatile markets you can make a lot more money by staying out of the markets than by trying to intensively playing the market.
6.  Profit is what is booked; all else is book profit
This is true for traders in all kinds of markets. But this is very true when markets are volatile. Take profits out at regular intervals. Volatile markets run a high level of overnight risk. So any overnight risk could wipe out your profits in no time. We have seen that happen in case of stocks like IT and pharma and especially in case of mid-cap stocks. The more profits you take off the table, the more liquidity you have to churn around.
This is not to say that Indian markets are likely to get into a period of volatility. But such low levels of volatility tend to encourage high risk taking and therefore makes markets volatile. It is best to be prepared with a plan to handle the market volatility!

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