Rough Sea? Here's Some Dramamine

 | Aug 12, 2011 | 11:00 AM EDT  | Comments
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Stock quotes in this article:

goog

,

anf

,

lulu

,

gld

,

slv

This week's market action would turn the saltiest sea captain into a seasick landlubber. The ceaseless, breathtakingly wild swings have made this old deckhand feel more like a jellyfish than a barracuda, and frankly a lot of us are looking forward to the weekend, just so we can get our sea legs back.

When the ocean swells so high that the waves appear ready to engulf your boat, use these tricks of the trade until you sail into a safe harbor:

Tip No. 1: Get Small

When volatility increases, my position size gets smaller. In order to explain this properly, we'll create a simple example using some random figures.

Fred normally trades Google (GOOG) with a position size of 200 shares. He also has a tendency to cut losses when the price moves against him by an amount equal to the 14-day average true range (ATR). Daily ATR basically tells you how much the price moves from high to low on an average day, based on the past 14 trading sessions.

About a month ago, in early July, Google's average movement from the high of the day to the low of the day measured about $10. A look back through time indicates that a daily ATR of $10 is very common for this particular stock. We could quantify Fred's risk this way: 200 shares x $10 ATR = $2,000 risk.

With the recent surge of volatility, the daily movement of GOOG has doubled to $20 per day. If Fred maintains the same position size that he used a month earlier, he's taking twice the risk because now he's anticipating a daily move of $20 instead of $10. Fred compensates for this added risk by reducing his normal position size by half. Now Fred's risk profile looks like this: 100 shares x $20 ATR = $2,000 risk. By trimming the position size, the risk remains the same.

 

GOOG Daily -- Average True Range
Source: TradeStation

 

Tip No. 2: Long and Short

Trading is a lot easier when the market has made up its mind to move in a dominant direction, whether that direction is up or down. But sometimes it's tough to get a handle on market direction, and this week was a prime example.

But you can make money even when the overall market direction isn't clear. For example, on May 27 I recommended on CNBC that traders go long SPDR Gold (GLD) and short iShares Silver (SLV). This is a good example of a non-directional trade; my rationale was that GLD would outperform SLV whether the commodities market moved higher or lower.

This type of trade eliminates market direction as a consideration and instead focuses on the relative difference in expected performance between two instruments. In another example, my friend and fellow Real Money columnist Brian Sozzi, who is an expert at analyzing retail stocks, likes Lululemon Athletica (LULU) more than he likes Abercrombie & Fitch (ANF). By going long LULU and simultaneously shorting ANF (equal dollar amounts, not equal number of shares), a trader is assuming the former will outperform the latter regardless of the overall direction of the retail sector.

 

LULU vs. ANF
Source: TradeStation

 

Tip No. 3: Know Thyself

You're a surfer. Every morning you grab your board and head for the ocean. You stand on the beach and look at the waves. What is the situation? Is the water choppy or smooth? Do you see nice, steady waves that roll up with consistency and a sense of order? Or are you looking at the inside of a Maytag washing machine, an aquatic vision of random mayhem?

Just remember, you have the option of taking your board and going back home. Sure, it isn't fun, but we're not here for entertainment; this is a business. Some people thrive in an environment of trading mayhem, but a lot of us don't.

Know thyself. If this kind of market environment is not to your liking, if you're not built for this kind of wild action, there's no shame in sitting this one out. Fortunes will be made and lost in this maelstrom of a market, and I'd rather imagine you relaxing on a beach or fishing in a stream than see you come out on the losing end. The market will be here when you return.

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