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CFDs
The calm before the storm
Jeff Cartridge - September 17, 2007
 With hurricanes currently raging through the Caribbean and the Gulf of Mexico leaving a trail of destruction, it is interesting to reflect on how this natural phenomenon is in evidence in the stock market. Between storms residents wait nervously for the next storm, wondering whether this storm is likely to destroy the balance they have in their lives. This is often referred to as the calm before the storm, pleasant for now, but with an air of foreboding. The recent volatility that has occurred in the stock market is quiet for now, with the market recovering most of the recent falls. The storm has passed or is there another storm just around the corner?
The volatility of the market can be measured by the Average True Range (ATR). The true range is the high to low range of a candle or bar, including any gap from the previous candle or bar. The ATR averages this figure out over a number of time periods and it can be thought of as the normal movement for the time period in question. In mid July the ATR of the ASX 200 (XJO) (averaged over a 7 day period) was at a level of 45. This means a normal day’s move was 45 points on the XJO. The recent volatility saw the ATR rise to over 150 in mid August and fall back to 85 today.
There are very few constants in the stock market as the market continually changes, but one thing does remain the same and that is the markets persistence in switching from trend to consolidation and back to trend. It is the trends where traders and investors make their money, while the periods of consolidation are harder to tolerate. This constant from trend to consolidation and back to trend has little impact on an investor who rides out all the market swings, but can have a dramatic effect on the more active trader.
During a consolidation period the market moves first up, then down, encouraging traders to enter a trade either long or short. Once the traders enter a position, the market then reverses without delivering profits to the trader. It is this seesawing backwards and forwards that frustrates traders and can create a series of consistent losses. Consolidations are necessary as the market stokes up energy for the next trend to emerge. It is the trend that provides the trading opportunity. These consolidation periods have been given names, ascending triangles, rectangles, wedges and broadening formations to name a few.
The breakout from the consolidation kick starts the next trend and then traders, chasing the new trend, that fuel the rally. Once all the traders have bought there is no more buying pressure and the trend enters the next consolidation phase. As a trader money is made on the trends. CFD account balances can swell very quickly when things are moving and this in itself represents an inherent danger. Having not only survived the storm unscathed the trader has profited from it as well. Traders now have more funds available to trade and also a higher level of confidence (overconfidence) in their ability to trade. As the market enters the next consolidation phase, this can have disastrous effects on the trader’s account balance.
One strategy I have found that works very well when trading CFDs is to withdraw money from my account when things are going well. The reduction in my account prevents me from trading too large a position during the consolidation phase and reduces the losses that I incur when the market enters the next consolidation.
With the Federal Reserve meeting on Tuesday 18th to decide on the level of interest rates in the US economy, this could be the beginning of the next storm. It is widely anticipated that the interest rate will be lowered at this meeting, but the question is by how much? If the Federal Reserve does not lower interest rates the market is likely to react sharply. If the Federal Reserve lowers interest rates “too much” then the market could also react sharply. This meeting may not be the catalyst for the next market fall, however the markets remain in a seasonally weak period through until the end of October.
Prepare for the next storm as it is coming even though the timing and the severity of the storm are difficult to determine.
Jeff Cartridge is the author of Supercharge Your Trading with CFDs. For more information go to www.superchargedreturns.com.au. Please note that the views expressed here are those of the author, not of CompareShares. Although all investing has some form of risk, CFD trading strategies are only for experienced traders and risk management strategies must be considered.
More articles from this week's CompareShares newsletter:
Stocks: American revolution comes full circle
Fundamentals: Paid off in dividends
Investing: The ultimate starter strategy for building wealth
Retirement: When work stops, but the bills don’t
Resident Trader: Taking a stab at trading forex
CFDs: The calm before the storm
Companies: Reporting season winners
Stock of the week: Blue skies for Hastie Group
International: Back to school for the US
Whatever your views, you can discuss this article - or any of Jeff's articles - on our message board Your 2 Cents.
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