When volatility strikes, it’s essential to understand that market conditions can change. The movements in trading assets can quickly change from small increments per day to significant swings. Volatility usually strikes when investors are complacent and do not expect market conditions to change. If you use technical analysis to trade the capital markets, you must understand that volatility can influence price changes. Therefore, your technical analysis needs to have robust rules. False breakdown and whipsaw price action can alter the dynamic in the capital markets, which means you need to pay specific attention to market price action.
What is Technical Analysis?
There are several ways to trade the capital markets, and one common practice is to use technical analysis. Technical analysis studies past price movements to determine the future direction of an asset.
Technical analysis describes levels of support (where there is buying) and resistance (where there is selling). It defines patterns, which can help you determine if prices are poised to reverse or continue to move in the direction of the trend. Some studies help you determine if momentum is increasing or declining. You can also define where the market is pushed too far too fast and is either overbought or oversold. Trend-following technical analysis studies help you decide which direction the trend is moving. You can learn about technical analysis through your broker’s education portal or several available books on the subject.
What Do You Need to Know About Technical Analysis When Markets are Volatile?
Past price action can help you speculate on future movements, but what happens when the markets become volatile? The answer is that technical analysis still enables you to determine how an asset could move. Still, you need to evaluate the outlook through a lens that reflects higher market volatility.
For example, one of the most widely used indicators is the relative strength index (RSI). The RSI is a momentum oscillator that can help you determine whether an asset is overbought or oversold. When the RSI hits a reading of 70, the underlying asset you are evaluating is overbought. When the RSI prints a reading of 30, the underlying asset is considered oversold. What is important to remember is that investments can stay overbought or oversold for an extended period.
You can see that the RSI on crude oil is overbought. Before you sell crude oil using the RSI as a gauge during a volatile period, you might want to have a confirmation indicator to help you avoid selling when the market is shooting higher. One way to do this is to wait for the RSI to cross back below the overbought trigger level (70).
Contrarian indicators such as the RSI and stochastics must be analyzed carefully when trading in volatile conditions. This scenario is the same for support and resistance levels. Support is a level where buyers are buoying prices, whereas resistance is where sellers have capped the further upside.
One technical analysis trading technique is to buy the breakout or breakdown. When the price of an asset moves below support, a trader might consider opening a Sell deal. When the price moves above resistance, he might consider a Buy deal.
A way to avoid a Buy deal on a false breakout during volatile market conditions is to wait for the market to close above resistance. The same technique can be used for a breakdown. You want to make sure that the price closes below support. If you trade on the close, you confirm that market participants are willing to go home with a position that has broken above resistance or below support.
There are two types of volatility. Historical volatility describes how much the markets have moved using a statistical calculation called the standard deviations of the returns. Historical volatility is reflected in percent terms. Implied volatility represents the market’s view of volatility. During geopolitical strife or climbing interest rates, implied volatility can rise as investors drive up the cost of hedging. When implied volatility grows, it tells you that options traders believe that prices will become more volatile. For example, when the VIX volatility index rises, S&P 500 index option traders forecast that future volatility will be higher.
The Bottom Line
Market volatility can make trading more difficult. Suppose you use technical analysis to trade the capital markets. In that case, you want to understand that you need confirmation indicators to ensure that you avoid catching the falling knife when volatility increases.
You can monitor future volatility by following and indexing the options of an underlying product. Implied volatility does not always correctly forecast future fluctuations, but it can tell you that a consensus of traders believe volatility will rise in the future.