Share Trading – Are You Adapting to Increasingly Volatile Markets?

The rules of share trading have changed again. I can recall in memory when you could perform due diligence with a company listed in the ASX sharemarket, analyze the fundamentals and buy with the expectation of long-term profit. Now, it seems, you need a degree in psychology and global economics in order to be a small-time investor saving up for retirement in these volatile markets. What changed?

Most upsides have their downsides and the sharemarket is no different. As things change for the better, some things change for the worse. Consider just two aspects:

• Globalization
• High-frequency trading

Share Trading and Globalization

Globalization is great for small businesses that have difficulty in securing capital. Are local bankers getting tight with funding for an expansion project? Not enough cash flowing through local equity markets? This is no longer a problem as an investor on the other side of the globe might be able to purchase shares through his broker, indirectly through a fund, with an American Depository Receipt if trading US exchanges, or through products such as CFDs that cover international markets. More businesses have access to the funding and capital they need to expand or stay afloat. This is good news right? Yes, but there is also a downside.

If the local sharemarket is being hammered by a bear market and you need to conserve cash, you are likely to sell all of your shares whether the companies are in Australia or on some remote island n the other side of the globe. Thus, a nervous trader living in Sydney Australia can have an impact on a small video-game business based in Taiwan. As the borders are lowered that allow free flowing capital to be traded around the world, the global sharemarket has become a giant bathtub of water that sloshes back and forth.

Is globalization horrible? No, it has its perks but it definitely changes the way we need to trade.

High-frequency Trading and Volatility

It used to be that you needed graph paper, a pencil, and a calculator to determine if a publicly traded Australian company was worth buying. Now we have sophisticated software run on computers capable of performing billions of instructions per second over mind-blowing Internet speed – and this is available at a low cost to the average retail investor. Data streams, complex strategies, and back-testing software that were formerly available exclusively to institutions can be served up to the small share trader sitting at home on the weekend, sipping a cup of coffee watching Saturday morning cartoons with his kids. This is great…right? Yes, but it also has consequences.

Now that computers can access hoards of data and compute it quicker than humans, it only makes sense that we would program our machines with our trading strategies to buy and sell for us. This has given way to a new breed of share trading called high-frequency trading. The ASX market is yielding to demand with the introduction of PureMatch and Chi-X - which will lower transaction costs, reduce transaction latency, and even give rebates when using certain limit orders. What are the consequences of computerized trading?

Current high-frequency trading research has found a link between stock specific volatility and certain transactions performed by these computerized traders. This provides more momentum to our already volatile sharemarket waters. An increase in liquidity comes at the cost of even more instability.

Share Trading and the Future

So where does that leave individual share traders? It leaves us at a cross-road where we can choose to adapt or be left behind. Just how does an investor rise to the challenge of competing against a volatile market? They do so through the judicious use of risk management techniques to lessen volatility and reduce downside loss. They can utilize some of the following methods:

• Diversification
• Market timing
• Position sizing

Diversification Comes in Many Flavors

If you only buy one stock, you are liable to experience high volatility when the industry group or sector turns down, or when high-frequency traders from around the world turn their attention to your stock due to some news item. How can you lower your risk? You need to buy more shares of different companies.

If you hold one company that mines gold, one that sells beef, a social networking stock, and a low-cost airline – you will have less volatility than if you bought a lot of shares in just one of these companies. Perhaps the price of gold goes up, the price of beef goes down, social networking continues to go wild, and a troubled economy sees less people flying. Put it all together and you have a portfolio that will move up and down with less volatility.

Want more diversification? Try out these tips:

• Have a mix of small and large capitalization shares
• Pick from companies headquartered around the world
• Choose from a variety of sectors and industry groups
• Select both deep value and high growth stocks

Finding investment products that trade independently from one another is becoming increasingly important as volatility continues to ramp up.

Market Timing Means Trading the Trend

As the saying goes, if you can’t beat them – join them. While it is a share traders dream to have a wide array of investment products that make up a well diversified portfolio that go up in bull and bear markets, the truth is that this simply doesn’t happen. When one market falls, the fearful cries are heard around the world as virtually all markets fall. Going defensive is no longer good enough. If you see the market softening, get out until things turn around.

To be sure, market timing techniques are far from perfect and much work remains to be done in this field. The methods of market timing and their reliability vary. Some use long-term moving averages, others use broad sentiment-based indicators, still others will use forward looking analyst estimates and future revisions to deduce where the market is heading. As we look ahead to global rises and crashes, knowing when, and in what direction, to position ourselves in the sharemarket will be one key to successful share trading.

Position Sizing and Risk Reduction

Imagine you found a stock that doubled its value daily. But on one random day during the year the price will fall to zero and all of your shares will be whisked away. Would you trade this stock? You’d be a fool not to. But how you traded this stock would make the difference between turning $10,000 into a billion or being flat broke. The key to success lies in position sizing.

If you re-invested 100 percent of your float every day, you would lose everything on the fateful day when the share value fell to zero. If you strategically invested your money, only allocating a certain percent of the float for each transaction and trading day, you could be among the richest people in the world. This one tip, having a position sizing system plus a quick way to make all the necessary calculations, will boost profits and keep you in the share trading game longer than the next guy. While researching market timing and diversification tactics take time, learning about position sizing is a quick way to improve your trading today.

Adapting to Change

Many traders wish they could take the knowledge, software, and strategy they have now to go back in time and trade former markets. While this makes for a nice dream, the reality is that we need to learn how to adapt to our current markets. The sharemarket is a dynamic entity that requires continual learning, adapting, and practice. If you haven’t already done so, now is a fine time to start diversifying your investments, learn about various market timing techniques, and use position sizing strategy and software to lower your risk and boost your profits when share trading ASX markets.