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Fast markets, big profits

Created:
7 March 2008
Written by:
Richard Hemming

Société Générale shareholders probably won't want to hear this but many traders are reaping record returns from the volatility being experienced by financial markets in the past month. Two traders we spoke to just prior to Christmas - Roy Mitchell and Chris Holden - have made their biggest returns in the month to date, racking up £135,000 profit on a capital base of £450,000.

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Both traders claim that the volatility of the market encourages them to take more risks, not fewer. Volatility is, admittedly, a widely overused term, but it generally refers to the movement of securities' prices over time. Given no stock-specific information, a company's share price may be affected by general market sentiment. When there is high volatility, share price moves can be much wilder (such as moving 3 per cent in one day on no news) than when there is little volatility (when the share price may not move at all).

Don't get in a Vix

A good measure of volatility is the Chicago Board of Exchange Volatility Index, known as the Vix. It doesn't measure volatility in shares, but tracks trading in options on the S&P 500 to indicate how much traders expect the market to move over the next month. Since the beginning of the year, the index has traded at a median of close to 27. This means that the average investor believes that there is a one-in-six chance that the S&P 500 index will fall 8 per cent or more over the next month. In 2007, the average level of the Vix was 17 and, in 2006, it was 13 (meaning the average trader believed there was a one-in-six chance of the index rising or falling 3.7 per cent in the next month).

Volatility is high because investors are nervous about impending economic doom arising out of the home mortgage crisis in the US and unforeseen and massive trading losses by investment banks - such as the €5bn (£3.8bn) loss at French bank Société Générale.

Traders who are making money claim that excessive volatility means that share prices revert back to their fair value, rather than making a concerted trend up or down. They can therefore make more money when prices get out of whack on no change in information, because they are confident that those prices will revert back to where they were prior to the fall.

Profiting from volatility

"January was my best ever month by a long way. Because the markets are moving up and down, it's fairly straightforward to make money. If you took a position, you knew it would go right for you, even if it went wrong initially,” says Roy Mitchell. Mr Mitchell is in his early 50s and stopped working full time three years ago after a successful career in the City as the tax director for the hedge fund manager Man Group. Since trading full time at the start of last year, he has made about £285,000 from starting capital of £50,000.

Chris Holden, on the other hand, started trading when he was 19, about 14 years ago, with £2,000 savings. So far, he has amassed a war chest of over £350,000 and, in the past month, has made £50,000. In total, he made £135,000 in 2007.

"The massive swings make it pretty easy to make money. The moves on stocks are over-exaggerated, so you get massive markdowns. If you sit with a pile of cash, you know when prices have gone too far down and can take advantage. Whereas if you're an investor you would have got hammered,” he says.

But watch out

Volatility doesn't always equate to profits, though - it just as often leads to losses because of the arbitrary nature of the price movements that it causes - see Chris Dillow's article "What volatility means (and doesn't)".

Experienced traders such as ADVFN chief executive Clem Chambers know that trading can giveth, but can more easily taketh away - especially in these markets. For every profit banked, a corresponding loss is also booked. "Most traders are getting killed in this market, because they don't have a way to make money. But those that do have an idea are making an absolute killing. For them, it's a case of getting all their Sundays in one week,” says Mr Chambers.

He adds that traders without a clear plan are most likely to win half the time and lose half the time. But because a trader always pays fees, his funds will be eroded and he will lose all his money, and sooner than he thinks.

"Volatility will show that you are going to die anyway, but you will die faster. On average, you can only buy and sell your portfolio seven times in a year before it's eaten up by fees," he says.

Have a system...

The seven trading experts we spoke to all say that the key to making money consistently by trading is to have a system. This doesn't mean any system, but one that gives the trader an edge on the market, and which factors in the costs of trading.

Successful - and for that matter unsuccessful - traders in volatile markets are making more trades every day. Graeme Dickson, who has been trading for the past nine years, says that he is making between 30 and 60 trades a day this year, well in excess of the 10 to 20 a day he was making last year, when markets were quieter. His reasoning is essentially self-preservation: "I do a lot of trades because when I make a false move, I take the losses quickly. When it goes against you, it happens fast."

Tim Hughes, head of sales trading at IG Index, says that on Tuesday 22 January when the US Federal Reserve unexpectedly cut official interest rates, trading volumes at the broker were one-third higher than the busiest day prior to that in August of last year.

...and watch your costs

In this environment, traders have to monitor their cost per trade closely. If Roy Mitchell traded directly in shares instead of spread betting, he says it would "wipe out most of my profit".

On an average trade, Mr Mitchell trades £10,000-worth of Man Group shares in spread betting, for which he pays £68 in commission and £2.25 for every lot that is filled. The latter amount might not sound much, but so far this year he has paid about £3,200 getting his orders filled.

In one of the many trades of his favourite share Man Group, he sold the shares at 550p and bought them back at 545.5p, locking in a gross profit of 4.5p, equivalent to £382 after brokerage fees were paid. This profit would only be £110 if he had to pay stamp duty of 0.5 per cent. Mr Mitchell trades spread bets because there is no capital gains tax on the profits, which is not the case for direct share trading and for contracts for difference (CFDs).

Every trader knows that minimising costs isn't going to keep them in the black. Beyond their trading system, the information in the market place is crucial to survival. Traders keep a close eye on stock exchange announcements, and any potentially market-sensitive research.

Darren Sinden, a sales trader at brokerage firm Lite Financial who started as a 'blue button' or a runner (the lowest person on the London Stock Exchange floor) in 1984, has seen many bull and bear markets.

Mr Sinden says the fall and subsequent bounce of shares in the UK's largest housebuilder, Barratt Developments, due to concerns over the credit crunch, illustrates the opportunities available in a bear market. Barratt shares fell almost 70 per cent over six months. They dropped over 30 per cent in one week, in early January, prior to bouncing 50 per cent from 315p to 494p in two days after investors were attracted by its 7 per cent-plus dividend yield and positive trading statement.

"The market was pricing in that it would never sell another house. The UK housing market has its problems, but there is never going to be a situation where there is no more housing demand," Mr Sinden says.

In the end, a trader's instinct can mean the difference between a big profit and a small one, according to Mr Sinden: "The question is, when will greed overcome fear? That's when [the price] forms a bottom and starts rising. We were fortunate to dip a toe on the up-leg, but in this market you are always quick to take a profit."

MORE ON PROFITING FROM VOLATILITY

Some tales from the coal face: seven experts who earn their living trading the markets share their views and experience. You'll need to register to read this.

Simon Thompson, the IC's companies editor, has an outstanding track record of market calls. He outlines his trading strategies. You'll need to be an IC Advantage subscriber to read this.

See also our free guide to trading derivatives.

Read more of our top features from 2008!

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