How Traders Can Manage Event Risk in Uncertain Market Conditions

Mihai-Alexandru Cristea 30/06/2022 | 15:35

Trading stocks, currency or commodities is not all golden. It is associated with great risks and uncertainties like the invasion of Ukraine and the increment of interest rate by the Central Banks.

 

In this case, you have to be a smart trader by paying close attention to macroeconomics and international events. This will keep you informed and help you build a strategy.

There is no guaranteed way of foreseeing the future, however there are guides to help manage risk. We will be discussing them below.

 

Goldman Sachs Insight Reports

Goldman Sachs Insight Reports are written by staff of the foremost investment bank, Goldman Sachs Group. These reports contain content articles crafted around securities, markets, structured products, rates, currencies and global economies.

It is an impetus marketing tool for expert traders because of its comprehensive, genuine, and original analysis. As a trader if you want to carry out fundamental analysis, this report provides information you need and broaden your thinking.

For instance, a Goldman Sachs insight report on a surge in retail trading or an increase in interest rate could show you how it will affect price or supply and demand in equity volume.

 

CFTC Weekly Commitment of Traders (COT) Reports

Having a good plan is essential for a trader and the Commitment of Traders Report is a weekly publication of the Commodity Futures Trading Commission (CFTC) to help you plan.  It helps to understand the market dynamism such as open interest in future and options. These interests include the long (buy) and short (sell) positions in the market.

The report simply tells you what commodity traders around the world are up to. When you know what they are up to, it can help you craft a good trading strategy. The reports can be downloaded as Zip files and comma delimited CSV format. If you want to go back in time the CFTC can give you historical data on 22 commodity futures markets dating more than 3 years back to aid your planning.

 

CME Fed Watch Tool

The CME Fed Watch Tool tries to predict what the Federal Reserve Bank is up to. This tool helps you foresee an interest rate hike before it happens. It uses futures contracts based on Fed Funds to predict changes in interest rate.

The more people buy fed fund future contracts, the more likely it is that an interest rate hike may be on the way soon. The tool also monitors dates for Federal Open Market Committee (FOMC) meetings and it assumes that interest rate hikes will be by 25 basis points.

Whenever an FOMC meeting is approaching the tool checks to see if investors are buying or selling off futures contracts. If they are buying massively then there’s a probability that the outcome of the next FOMC meeting will be a hike in interest rates. The tool then goes ahead to compute a binary tree with the following branches:

  • Maintenance of current target
  • A switch to a new target 25 points above or below previous interest rate

 

How to Manage Event Risks

Use Option Contracts

An Option contract gives you the right, not the obligation to buy or sell a specific quantity an underlying asset at a preset price called the strike price within a preset timeframe.

Options are exchange traded contracts with set contract specifications. To buy an option you must pay a premium to the option seller.  They can either be call options that give you the right to buy, or sell options that give you the right to sell.

Example if you fear that the price of crude oil will rise from £80 to £90 one month from now, you can enter into a call option contract with your broker.

This contract will be designed to give you the right but not the obligation to buy a given quantity of crude oil at £80 per barrel in one months’ time. You will pay a premium to the broker or option writer before taking hold of the contract. By doing this even if the price increases you still pay the strike price of £80 per barrel.

However, if the price of crude oil should fall or remain static you lose the premium you paid to buy the call option contract.

On the other hand if you feared the price of oil would fall from £80 to £70 you would have bought a put option contract instead. This would have given you the right but not the obligation to sell a specified quantity of crude oil at £80 one month from now. Risk is managed because even if the price falls, you still sell at the strike price of £80.

Option contract helps you to manage event risks, especially against the volatility that often comes with it. It avails you the opportunity to set your trade ahead of a major economic event.

 

Use CFD Contracts or Spread Betting

Other than using options, you can also enter into a CFD contract for an instrument for which you want to manage your risk & hedge your positions.

For example, if you hold shares in retail companies but are worried that they could go down because of low demand. Let’s say you think the shares of retailer Tesco are going to go down because of a decrease in demand due to higher interest rates & rising inflation.

You can hedge against this risk by buying a CFD contract on Tesco shares. For this, you can place a sell order with a CFD broker or also with a spread betting broker. There are some tax advantages to spread betting like no CGT & stamp duty.

But it is important to know that only UK-based traders have the option to choose between spread betting or using CFD contracts to hedge their risk. This is because spread betting brokers are legal in the UK, but they are not legal or an available option in most of the EU countries.

 

Close Your Open Position If Foreseen Risk Is Uncontrollable

In a case where your open position is exposed to uncontrollable risk, you can close it to mitigate further loss. You can do a partial position closing, or close all your open positions depending on the level of risk you are exposed to.

The need for you to close your position often occurs when a major fundamental factor or important economic events such as the Central Bank Meeting, Earning Report, Coronavirus Market Impact, Global Recession or Brexit affect your trade set-up.

In such an occurrence, you are very likely to be exposed to enormous risks which could lead to a significant loss of capital. Therefore, closing your open position until the market is stable could be the best thing to do.

 

Reduce Your Trading Capital

Risks and uncertainties are integral parts of the market. They are unavoidable. During major economic events, the market will be very liable to risk and uncertainties.

The market is not in your control and neither does it respect your sentiment. Experts suggest limiting risk exposure by reducing your trading capital before a major economic event. Most importantly, do not risk more than what you can afford to lose.

 

Set your Stop loss Based on Volatility

A stop loss is an automated order you set to exit your open position once the price of the asset you’re trading crosses a stop price you set in advance.  It is the exit you create for your trade. While stop-loss could be used arbitrarily, one of the best ways to place a stop loss is doing so based on price volatility.

Experts warn that if you place a stop loss without logic, you may place it too close to the market price of the asset and when volatility is high, you end up getting stopped out frequently. Some call this the ‘death by a hundred stops syndrome’.

Volatility stop loss technique helps you locate a proper predetermined point to place a stop loss order which is not too far from the market price and not too close to it. The predetermined points could be determined with the use of some volatility indicators such as:

  • Average True Range (ATR) – is a technical indicator available on every chart that tells you how volatile something currently is based on how volatile it was in the past 14 days.

Assets with a rising ATR graph are highly volatile and a falling ATR graph means a fall in volatility. ATR is always displayed as a separate chart below your price chart.

If you’re long on EUR/USD  exchanging at 1.0644 and ATR reading is 100  then you can set your stop loss below the current exchange rate at a multiple– say twice the ATR figure so stop loss will be set at  ($1.0644 – 2 x100 pips) = 1.0544.

If you’re going short on EUR/USD you can also set your stop loss above the current exchange rate at twice the ATR figure. The multiple can be 2, 3 etc., depending on your risk appetite.

 

  • Bollinger bands- are used to measure market volatility and identify overbought and oversold conditions. When the band is thin it depicts low volatility and when the band is wide it depicts high price volatility. You can set your stop loss above or below the Bollinger bands.

There are many more types but you should know that they are not perfect. You must know the risks when using volatility indicators, you should combine more than one to make a choice.

For example, ATR only tells you how volatile the market is but doesn’t provide you with buy or sell signals. When you know how volatile the market is you can then decide where to place your stops.

Most indicators depend on historical data, and may sometimes give false results. The way around is to combine more than one indicator then compare the results.

For example, for volatility prediction you can combine the ATR and Bollinger bands and for trend prediction you can combine moving average and ADX indicators. By doing this you get a clearer picture and reduce the tendency of wrong results.

 

Considerations

No doubt, trading the capital market comes with a lot of risks and uncertainties. The risks and uncertainties can, however, be effectively managed if you have a plan and follow it religiously.

You should not allow your emotions to override your reasons, especially during high volatility. In other words, learn to manage your emotions, do not trade more than what you can afford to lose and always keep an eye on news and events.

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Mihai-Alexandru Cristea | 02/08/2022 | 10:15

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