The Lurking Danger of Low Market Volatility
It's counterintuitive but experienced traders understand that this specific risk increases as volatility subsides
- When implied volatility dries up in the stock market, make sure not to size your positions larger than you normally would
- Volatility can cause a profitable trading environment but oversizing kills all accounts eventually.
- When trading in low IV, discipline is key.
When stock market volatility reaches very low levels, you tend to see many more up days than down days. Additionally, the overall movement on a daily or even intraday basis seems very small.
Ironically, this type of market environment is the most prone to a very large, sudden drop. Most traders don't think about this possibility because we have seen daily intraday ranges (defined as the day's high minus the day's low) in the S&P 500 be as small as 10 points or fewer.
Compare this to upward of 200 points in the midst of the 2022 bear market. In this type of market, we generally see traders do the following thing that could be detrimental to their long term success: Making up for lower market movement with larger than average trade size.
Why should we stay disciplined?
Although tempting, increasing trade size and capital outlay is like playing a game that you will eventually lose. Why?
When markets get dull, you tend to look at possible movement through a different lens. You used to see a 2% or greater move in the market pretty frequently, and a 0.5% move qualifies as a "big day."
On trades where you used to set profit targets of $1,000, you now have to reduce to $200 for the same unit size. This may result in the brilliant idea that can be summarized in the following thought process: "Well, if I was able to handle $1,000 swings, I can trade bigger to make my current trades carry that same amount of risk!"
How leveraging risk can kill
The issue is actually simple but severe: At some point, the market will become very volatile again. Now it may not be for a month or a year or even longer, but when it does, your new extra-large trade sizing is going to carrying massive risk.
Think of it this way: you used to have $200 of risk on at any given time, then with the added volatility that same trade size but higher volatility caused the risk to go to $1,000 on any given trade, then market volatility dropped back to where your risk is now $200 per trade. You decide to size up 5x to get back to the $1,000 risk per trade.
Then after a while, market volatility goes back up, and your 5x trade size has caused your portfolio to take on $5,000 in risk per trade. This is how size kills. Moral of the story: Make sure to mind your trade size and stay disciplined, especially coming off a period of amplified market volatility.
Anton Kulikov has a decade of trading experience. He leads research content creation at tastylive; appears on over 20 live shows, including Futures Power Hour, Options Jive and Research Specials LIVE ; co-authored bestselling investment strategy book Unlucky Investor’s Guide to Options Trading; and has contributed research content for Luckbox magazine.
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