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Volatile markets are a problem, but only if you don't know how to trade them.
Unless you have a plan that you'll actually execute when volatility kicks into high gear, you're going to struggle - and you may do something you'll regret.
While there are lots of ways to trade volatility itself, some of which I told you about a few weeks ago, there are only a few ways to play volatile markets.
Many investors are stricken with panic when it comes to the thought of losing stocks they love; I get it, it can be scary. But you don't need to panic; you can own great stocks at much lower prices, and you can buy more of them.
Here are the three key things to remember when trading volatile markets.
Patience Is a Virtue
There are two types of investors in this situation; you're either one, or you're the other. You are either ready to be patient during volatile periods, or you aren't.
On one hand, if you're a long-term investor - meaning you have a time horizon of at least three (but preferably five) years - before you even think of selling stocks, rebalancing your portfolio because your life needs are changing, or you want less equity exposure and more fixed income to live off, don't do anything when volatility rears its head.
Of course, that's assuming you love your stocks. And by that, I mean you're loyal to the companies you own.
You're loyal to those companies because you love what they do and how they do it, they have tons of loyal customers, they have tons of revenue, and they're seriously profitable. That's love.
Those are the kinds of stocks you should own for the long haul, for retirement, and for real wealth creation.
If you love your portfolio because you own those kinds of companies, don't worry about volatility. Don't do anything when volatility scares everyone else. It'll pass, and stocks will keep going up.
The only thing to think about if you own stocks you love is if you're going to add to your positions when the market becomes excessively volatile. Embrace volatility and add to your positions when everyone else is freaking out over how volatile the markets become, and how it's suddenly dropped.
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On the other hand, if you are afraid of the market, if you don't have a long-term hold plan, if you are one of those types of investors who react by doing something when you feel you must, here's what you should do when volatility scares you.
First, understand that volatility is a two-way street. If you're afraid of it because you're afraid it will knock the market down and your portfolio and fortunes with it, that's valid. It can do that.
But volatility, especially when it knocks markets down hard, can be your best friend. That's because it can give you great entry points to buy stocks or add to positions you already love.
My "protection mode" is and always has been the same. I have stop-loss orders in place on my stock positions. Even though I have stocks I love, I still use stops. That's not because I'm not an investor, it's because I've been a trader for more than 35 years; it's what I do. I'm comfortable trading out of stocks I love because I know I'll get back in.
The stocks I love regularly go up in price. And because I use stops, I have to adjust my stops higher as the stocks I own go higher.
I use technical analysis to figure out where I want my stops, and you should try to do the same. If you're not comfortable with technical analysis, you can use "percentage bracket stops."
There Is Science Behind It
On the technical side, I look at where the best, closest "support" is as a stock rises. If support is close to where my stock is trading, I'll go down to the next support level and put a stop there.
There are only two bad things to consider when using stop-loss orders. Number one is that you get out too soon or too often, in which case your stops are "too tight." And the other bad thing about stops is not getting back in when you get stopped out.
Instead of using technical analysis to figure out the best place to apply your stops, you can look at your stocks and figure out how volatile they are and how much they move up and down in a month, in a quarter, on average, and in percentage terms.
If your stocks trade within a 5% range up or down (or even up to 10% to 15%), use a stop at the lowest level of the percent range as your stop.
As your stock goes up, past the upper percentage range it's been trading within, raise your stop up to the next level, which now may be what the upper bracket of the previous percentage range bracket was.
There's some science (and a whole lot of luck) in having the right stops, not being hit when you don't want to be, and getting out on a stop when it was the right move to make at that time.
The other bad thing about stops is that they take you out of some great positions, and you might not get back into the stocks you loved after the volatility passes.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.