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Trading during high volatility

There are two elements a forex trader needs in order to gain profits in the forex market.

Firstly, the trader needs a profitable trading strategy and one that is successful over a long period of time and also works in different market conditions. Secondly, the trader needs to have a clear money management method. Both of these two are important or otherwise, the trader would not be able to enjoy the benefits of an efficient forex trading strategy.

Additionally, in order to make money in the markets, the trader needs a third element of volatility.

If the market is flat and the range is tight, even the best forex strategy will not help in most cases no matter how good a trader you are. Good practice is that when the market is trading in low volatility, for example during holidays, take the day off and do not risk your money instead of keeping your trades open or going long when you are not sure what the outcome would be when the markets open.

The forex broker you deal with also plays an important role especially during times of volatility. Some market makers tend to stop all trading during times of economic news releases, thus preventing you from making any profits (or losses) from the markets during those “opportune” times.

Non-dealing desk brokers are highly recommended because they offer an ECN dealing execution. What this means is that there are no dealing desks and thus no counterparties to your trades. It allows you complete flexibility during periods of high volatility.

What should you do when the market is extremely volatile?

Fast changes in the intraday session, wide gaps between trading days and extreme volumes might cause great loses and inexperienced traders might blow their accounts if they do not trade carefully or not pay attention to the market factors.

High volatility is usually caused by fundamental events, such as the European debt crisis, geo political crisis etc. As stated, high volatility in forex can be both an advantage and disadvantage for forex traders.

Swing trading out, Intraday trading in

Swing traders are the ones who keep their positions overnight and make their decisions according to the daily chart. Swing traders also tend to suffer from extreme volatility situations. There is not a clear trend as gaps are opened every other day and stop-loss orders are triggered close to the positions opening.

Therefore, keeping positions open overnight in such an extreme situation is riskier than usual and you might want to avoid that until the storm fades away. If you insist on making a swing trading, try using smaller amounts than you normally would and set aggressive stop-loss orders.

On the other hand, high volatility is usually a big celebration for intraday traders.

You can make quick trades, ride on high-range momentums, reverse from long position to short position and vice versa. However, it can also pull you to over trading and even gambling so you need to pick your trades wisely.

When dealing with high volatility, you should also look at the quotes. Forex trading quotes can be of two types. Level 1 and Level 2. In the next section, we talk about these quote types.

Level 1 and level II quotes

We have all heard the phrase taken from George Orwell’s Animal Farm: all animals are equal, but some are more equal than others. The same is true in the financial markets, as some traders are definitely more equal than others. No issue best exemplifies this than the issue of pricing in the market.

There are two different types of pricing/quotation of prices in the financial market:

  • Level I quotes
  • Level II quotes

Level I Quotes

This is the most common quote type. It shows the real time bid and ask prices of an underlying asset in the Nasdaq or Over the Counter Bulletin Board (OTCBB) markets. Level I quotes represent the most basic price quotation system that most traders are given by their brokers.

Put another way, most retail investors/traders will see the price of the asset they want to trade as a Level I quote.

Very little information is given by the Level I quote. For instance, there is no information as to what quantity of the asset the market maker is buying, which market maker is either offering the asset for sale or purchasing the asset, aside from just knowing the bid/ask, the trader has no access to the information detailing the market depth of the order.

A Level I quote looks like this:

Stock ABC = 120.25/120.29 (bid/ask)

It is all so basic. This puts a limitation on the trader’s ability to know what is going on around him in the market. For instance, a market maker offers a security to the trader where they have a long position. They also have a larger order for this position. In such circumstances,  it is not in your best interest to go against the market maker.

Such insight can be the difference between a win or a loss, and this underscores the limitation of the Level I quote.

Level II Quotes

In contrast to the first kind, Level II quotes are used by institutional traders or traders operating in an Electronic Communication Network (ECN) environment. The Level II quote provides the entire information in the order book for the asset. The trader gets to know which market maker(s) has an interest in the asset. Then, the quantity the market maker has bought the stock, and the quantity of units purchased. A Level II quote looks like this:

Stock ABC = MLCO/58.5/100

In this quote, we can see that Merrill Lynch purchases 100 contract units (10,000 shares) of stock ABC. This trade comes at a price of $58.5 per share. The market participant, Merrill Lynch in this example connects with a 4 letter ID on the Level II quote.

Algorithmic trading bots also make use of level II quotes.

Understanding how the quotes work is important for you as a trader. Without know the quotes, trading during high volatile news events can be risky.

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