This post originally appeared in FutureSource’s Fast Break Newsletter on May 17, 2011 where Craig Turner is a regular contributor on various futures trading topics.

Trading in volatile markets provides extraordinary opportunities but it also carries more risk.  For more aggressive traders, volatile markets can lead to larger than normal losses, but they can also provide rare opportunities that can be highly advantageous for your trading account.  If you are going to trade in volatile markets, or if you have positions and the markets become volatile, you need to know how to recognize the warning signs and navigate through the storm.  You have to be able to manage risk if you want to take advantage of substantial price moves.

1) Margins are Inadequate Guidelines in Volatile Markets

When a market is volatile, the first thing you should do is make sure the margin requirements are greater than the daily ranges in the market.  For example, when Silver was trading from $20 to $50, the exchange and clearing firms did not raise margins.  Anyone who has traded silver knows it can trade down 10% on its worst days.  In my opinion, margins should be at least a day’s trading range for any contract.  When Silver traded at $15 and $20, the biggest down days would be $1.50 to $2.00.  Margin for silver would be around $10,000 ($2.00 in the big contract).  This was appropriate for the contract.

Looking back, there was a big warning sign the Silver market could become a volatile market.  The red flag was the exchanges and clearing firms not raising margins as the Silver traded to $30 and then $40.  As the market climbed higher, the daily trading range was higher.  Margins stayed the same.  This meant that it was possible that too many traders were in the market without enough capital, which is always a recipe for volatility.

If you are trading a volatile bull or bear market, you need to use the possible daily trading ranges as a guideline for capital.  Exchanges and clearing firms are slow to act.  They are rarely ahead of the curve on margin issues, and they are usually caught off guard and have to increase margins after the damage is done.

By understanding that you need more capital on hand to trade volatile margins, you will have more staying power than the average trader.  The trader using margin as a guideline will not be able to stay in the position.  A trader who understands that volatile markets can have higher trading ranges than the exchange margin should be able to ride out the storm better.

2) De-leverage When the Markets Become Volatile

When the markets are volatile, it is not the time to double up.  If you are trading two contracts, it is the time to de-leverage and just trade one.  If you are trading one standard contract, it might be the time to shift gears and trade the mini contracts for a while.

When the markets become volatile, it doesn’t mean you have to stop trading.  Your opinion of the markets can still be correct but outside factors may be an issue.  For example, the US Dollar, European nations needing bailouts, wars in the Middle East, the natural disaster in Japan, can all affect the markets.  In my opinion, what you need to do is take on less risk during these times.  The only way to really achieve this is to de-leverage. The best way to do this is to reduce your position size so you can stay in the game.

3) Spreads May Help With Reducing Volatility

One possible way to hedge against volatility is to trade futures spreads.  Let’s say a trader has a long corn position in December 2011 corn.  The grain markets and commodity markets start to become volatile due to the US Dollar rallying because there are fresh concerns about the Euro and its member countries defaulting on their debt.  The soaring dollar is going to hurt the trader’s long Dec Corn position.

Let’s say the trader is very bullish on corn, understands the market could go down in the short term, and wants to stay in his position for the medium to long term.  Using the spread methodology, the trader would then short a different month in Corn to attempt to protect himself.  In this case, the trader would most likely short July 2011 Corn or Dec 2012 Corn.  Either way the trader can now better ride out the storm until the volatility passes.  Once the trader is confident again that corn will start moving higher, he just lifts the short corn leg of the spread and leaves the long Dec 2011 Corn position on.

What is nice about this option is the margin the trader was using for long 1 contract of corn (over $2000) is now about $500 for the spread.  Not only is the trader potentially reducing risk, he is also reducing margin requirements.  The trader does not have to come up with more capital to short an extra contract.  Because, on average, futures spreads reduce risk when compared to outright positions, the exchanges recognize this and require less margin.

4) Options Offer Protection on Existing Futures Positions

There are two ways to use options in volatile markets.

For those trading futures, you can use options to hedge against short term volatility.  Let’s say you are long December Corn and you think the market could sell off 20 to 30 cents before rallying a full dollar.  The trader can keep the Corn position on and also buy a December Corn put.  If the market really does sell off 20 to 30 cents, the trader can liquidate the option for a profit and then hold Corn as he looks for the bottom to come and the rally to start.

The second way to use options is to not trade futures during times of volatility and just use Option Spreads.  Let’s say you are bullish December Corn, you think the markets are going to be volatile, but you want a bullish position.  By using a bull call spread in December Corn, the trader has a defined risk and reward, and the short term volatility should not change the value of the spread nearly as much as a futures contract or just being long a single call option.

5) Summary

When the markets become volatile, traders need to have more capital for their positions.  Greater daily trading ranges means traders should have more capital per position.  If the trader does not have the capital for the increased volatility, they need to de-leverage.  One way to de-leverage is to either reduce position size or trade mini contracts instead of standard contracts.

Another way to de-leverage is to use futures spreads.  Traders caught in a volatile market can use futures spreads to potentially reduce the risk in their position.  They can leg out of the spread into their original position after the smoke has cleared.  Finally, traders can also reduce risk and de-leverage by using options with their futures position or just use option spreads, like a bull call spread or a bear put spread.

All in all, the most important thing to take away is that when the markets are volatile, traders need to reduce their risk exposure.  While volatility may provide extraordinary profit potential, it also may lead to greater than normal risk.  Traders need to manage this risk while still being able to take advantage of price movements in the market.  By reducing their risk exposure, traders will be able to stay in the game and have the opportunity to go after substantial price moves.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.