How To Trade In Challenging Times

By Ed Ponsi

Okay, so things are rough out there. Bear Stearns, Lehman Brothers, Washington Mutual, American International Group, B&B, Freddy and Fannie and the rest of the gang have all either gone to that Big Vault in the Sky, or are on life support. The proverbial "other shoe" has dropped so many times that we've all lost count – and the carnage isn't yet complete. But just because the world is facing financial Armageddon, and long-term investments are falling apart faster than the New York Mets in September, that doesn't mean your trading account has to suffer. In fact, some traders thrive in this rock 'em, sock 'em environment. Just take a look at the volatility in the Great Britain Pound – U.S. Dollar currency pair (symbol GBP/USD). Note how the candles on the left side of the chart are much bigger than on the right, indicating that the daily range has expanded dramatically. Also, take a look at the Average True Range indicator (ATR), which shows us that the average daily range of GBP/USD over the past 14 trading days now exceeds 300 pips! (See figure 1).



Figure 1: GBP/USD's average daily volatility has risen to over 300 pips. Source: Saxo Bank

This level of volatility hasn't been seen since the year 2000, and the type of wild action it creates will be welcomed by some traders and avoided by others. Here are three key thoughts to help you trade safely and securely during these challenging and historic times.

Nimble – Things are happening quickly out there, and the wide swings in volatility are causing markets to move faster and farther than before. In fact, volatility in the currency markets is at its highest point since the year 2000. What's a trader to do? Traders looking for quick intraday moves need to keep their finger on the trigger at all times – especially when they are already in a trade. The game changes quickly, so be ready for action at a moment's notice. Put your mouse cursor directly above the exit button, and keep your finger poised above the mouse. That way, you'll never be taken by surprise, and you'll always be ready to close your position.

Pip Slip – Prepare for slippage, as fast moving markets may cause some surprising fills. This is a common occurrence in the stock markets, but currency traders have been largely immune to slippage - that is, until the recent spike in volatility changed the game and turned the trading world upside down. How to deal with this problem? Plan ahead and don't be surprised when you get a bad fill; in fact, make it part of your game plan. When performing your calculations, assume that the price you receive for both buys and sells will be slightly worse than you would normally anticipate. Not only will you be prepared for a bad fill, but you may find yourself pleasantly surprised when you get a good one!

Park It - Trading in this fast-paced environment isn't meant for those with a nervous stomach. In fact, many of us would be better served by simply staying out of the trade and watching from the sidelines until the markets settle down. Always remember that part of our jobs as traders is to know when to avoid trading. The truth is you should never feel as if you absolutely have to place a trade, and you should only place trades when you feel that the odds are in your favor. Selectivity is the key; you will make more money from one good trade than you will from ten mediocre trades, so maintain your focus and only take the best trading opportunities.

Question of the Week

Q) Ed, I keep hearing about LIBOR in connection with the bailout but I'm not familiar with this term. Can you please explain what it means and why it is important to traders?

Ed Ponsi) Thank you for your question. LIBOR is short for London Interbank Offered Rate, and it represents the cost of borrowing dollars overnight in London. On September 30th, the last day of the third quarter and the day after the bailout plan first failed to pass through Congress, LIBOR spiked an incredible 431 basis points to 6.88%. Let's think about that for a minute; banks are charging each other an annual rate of 6.88% for overnight loans! They must be pretty frightened to charge such a high rate, perhaps because no bank wants to lend money, only to find out later that the borrower has evaporated.

In a way, you could say that LIBOR is a "fear gauge", and it is telling us right now that banks do not want to lend money to other banks except at ridiculous rates. This is despite the fact that the Fed and other central banks are constantly pumping liquidity into the system, jamming the banks full of cash so that they'll be more willing to lend. Many of the banks are just hoarding this added capital for their own needs instead of lending it out to others, defeating the purpose of the Fed's actions.

Right now we are seeing strength in the U.S. dollar, and that is because the USD tends to perform well when fear is high. But this will pass; fear is a temporary condition, and as bad as it may seem right now, things will eventually get better. When they do, watch out – the bill will come due for this mess, and when it does, it will weigh heavily on the greenback. Enjoy the USD rally while it lasts.

Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.