There are times when even the keenest surfers stay out of the water. Tempestuous waters are too dangerous. Tiny waves aren’t worth the trouble. Leveraged traders who know when the market’s extremes are unlikely to give them the results they want are better off than those obsessed with being in the market to avoid missing out.
But whether you can extract gains from markets in a consolidation phase depends a little on your experience and the number of strategies you can use safely. A consolidation phase is one in which buyers and sellers tussle with each other to find a price balance, usually after a long rally or decline. Prices often trade within a narrow range and volatility drops.
That’s where we are now in the sharemarket. The Australian S&P ASX 200 share index so far this year has mostly stayed within 200 points of 4750, where it started. In the closing quarter of 2010 it was bound even more narrowly, unable to break above 4800 or below 4600.
Narrow ranges make for difficult trading conditions. CFD traders like long rallies, with regular pullbacks (downward corrections) that give them a chance to take profits and get back on board. So how do they respond to choppy markets that change direction often but don’t really go anywhere?
The obvious responses, the textbook ones, are to trade shorter term, tighten stops and increase position sizes. A tighter stop is a stop-loss order closer to the current price, getting you out on a smaller move, but enabling you to trade a bigger position so you still make a profit on a favourable small move.
Getting the exact level right is a matter of learning, and depends on your time horizon. Wider stops are for longer-term traders. On a recent day in the Australian sharemarket, the index began by dropping 1.0 per cent on a negative lead from overseas, but later cut this loss to 0.3 per cent. A tight stop would have tipped traders out of their positions; longer term traders need to give their stops a little more room.
If you know the market is trading in a range, one strategy is to buy at the bottom of the range and sell at the top. Because it’s constantly changing direction, you may need to be more aware of the share’s price movements within a day, which means more time monitoring the market.
Another traditional strategy for sideways-moving markets is to sell or write options in order to earn premium. But this is for well-funded professionals who understand the complexities of options - it’s extremely risky unless you know what you’re doing.
Although options can help traders minimise or capitalise on volatility, they tend to be expensive and cumbersome to trade, even after the ASX’s decision to reduce the minimum contract size to 100 shares, down from 1,000 shares.
Some CFD providers, including IG Markets, offer options contracts on their platforms, traded as CFDs and settled in cash rather than by delivery. But traders looking to income generating strategies on specific stocks or a wider range of options contracts should consult a specialist options broker.
Ric Spooner, chief market analyst at CFD provider CMC Markets, has four suggestions for traders looking for rewards in a trendless share market.
1. Diversify across asset classes and sectors to maximise opportunity.
Spooner points out that one of the advantages of CFD trading platforms is their ability to access not only international shares but also foreign exchange and commodities. “I’m an advocate of looking at the big markets in our time zone, for example Hong Kong and Japan, and trading those via CFDs is no more difficult than trading Australian stocks.”
He says technical traders have an advantage in this regard because chart patterns and entry and exit signals learned in one market can be applied, with appropriate adjustment, to other markets. “You familiarise yourself with the methodology and then cast your net wider for suitable instruments.”
He points out that most share traders will have a beginning understanding of commodity markets from their study of resources stocks. “So to familiarise yourself with direct participation in the precious metals, base metals, and grain markets is not a big leap. Then there are the major foreign exchange (FX) markets. If you’re trading stocks on fundamentals, that may involve having a view on the economy, so it’s a stepping stone to trading currencies.”
2. Consider short selling.
Most methods of selecting trades will identify selling opportunities as well as buying ones, Spooner says. “Assuming you have good strategies, which is necessary for success, then increasing opportunity this way, with appropriate risk management, is the way to go. Why constrain yourself to trading long only? It’s something traders need to get used to against a background of experience in buying and holding. If a trader is there to make a profit, it [a preference for trading long] can be overcome."
3. Diversify your strategies.
“Strategies can be categorised as trend following or range trading. It’s a good idea is to have a mix, or at least one of each of those, to deal with situations where markets are range bound so that you’re not sitting on the sidelines. What that amounts to is to buy using support levels and to sell at resistance,” Spooner says. Support is at the bottom of the range, where the price is more likely to bounce off rather than break through, while resistance is the top, where the price has trouble rising.
“As a general observation, the range needs to be big enough in relation to potential losses to make it sensible. And again, you can apply that to all asset classes,” he says.
4. Know when to stay out.
There are times when traders must accept the fact that a market is so range bound and lacking in volatility that they need to avoid the temptation to trade for its own sake. “The rewards are too small compared to the risks and costs,” he says.
>>Back to the newsletter to view other articles - June 13th 2011