How To Trade A Choppy Market: The markets are always in motion, moving up and down in response to economic reports, business and industry news, geopolitical events, and general public sentiment.
In most cases, the movement trends in a single direction – for example, markets went up when news broke that a COVID vaccine was approved. They generally continued in that direction for a period.
However, news and world events aren’t always interpreted the same way by everyone – and in some cases, there isn’t enough information available to prompt consistent investor behavior. That results in a choppy market – one of the most challenging scenarios to navigate.
Understanding how to trade a choppy market is critical to keeping your portfolio intact during periods of uncertainty.
What is the Definition of a Choppy Market?
The best way to define a choppy market is to say that it is a market with no clear trend. Orderly markets trend up or down, giving investors an opportunity to make their bets.
There is no discernable pattern to the movement in a choppy market. The changes come too quickly and unexpectedly for investors to react in a thoughtful manner. In most cases, this results in a loss on almost every trade, simply because the movement occurs so rapidly.
The definition of a choppy market differs from that of a sideways market. In a sideways market, there is little or no motion at all.
It is, in essence, the absence of a trend rather than sharp changes between ups and downs. The strategies that work in a sideways market are quite different from those of a choppy market and shouldn’t be attempted unless the right conditions exist.
How Do You Identify a Choppy Market?
From a visual perspective, choppy markets can be identified by the rectangular pattern that forms on price charts. You see highs and lows in the defined period, but they stay between the same peak and valley prices.
These are often referred to as the resistance and support lines – the horizontal lines that indicate the highest price at which investors will buy and the lowest price at which they will sell.
When connected by vertical lines marking the relevant timeframe, these horizontal lines create a rectangle.
What Causes a Choppy Market?
There are three primary causes for a choppy market. First, when there is balance between buyers and sellers, neither has a lasting impact on prices. As a result, prices fluctuate with every trade, which results in a choppy market.
Second, uncertainty can create a choppy market. That is often seen when there are reports of a critical event but information is incomplete or investors interpret the event differently. The choppiness typically resolves once more details are available.
Finally, choppiness can develop when there is no news at all. Instead of a sideways market, prices move up and down while investors wait for a catalyst to prompt consistent movement.
How To Trade A Choppy Market
The most tempting method of trading a choppy market goes back to basics: buy low, sell high. In this case, that means buying when prices drop to the support line and selling when they hit the resistance line.
While it is possible to profit with this method, it is riskier than it sounds. Choppy markets inevitably resolve and settle into a trend, and there is no telling when that might happen or what that trend will look like.
If you have the ability to monitor the market carefully, and you have the precision and discipline to trade at just the right moment, you may be successful.
Otherwise, consider these strategies instead:
Covered Call Strategies
Those comfortable with options can trade a choppy market through covered call strategies.
Essentially, you purchase the shares, then sell call options to generate income from the premium on the options.
The holder of the call has the option – but not the obligation – to buy your shares at the strike price.
You profit from time-decay as the option value erodes as expiration of the option approaches. Essentially your bet is the share price doesn’t rise above a certain pre-determined level, the strike price which is generally placed above an existing resistance level.
High Dividend Stocks
In a choppy market, you can’t rely on investments increasing in value. A more effective strategy is to choose high dividend stocks.
Though share prices may fluctuate, you can count on returns from the dividend payouts.
Examples of high dividend stocks include the following (as of February 2021):
- Altria Group – 8.1 percent yield
- Annaly Capital Management – 10.5 percent yield
- Chimera – 10.57 percent yield
- Duke Energy – 4.1 percent yield
- Energy Transfer LP – 8.94 percent yield
- IBM – 5.4 percent yield
Keep in mind that the underlying health of the company remains an important factor in your decision to buy.
Occasionally, businesses pay more in dividends than they can comfortably afford, which puts both the dividend and your underlying investment at risk.
Sell Put Options on Stocks You Would Happily Own
Put options give the holder the right to sell their shares to you at the strike price. When you sell puts, you are obligated to buy the holder’s those shares if your put option is assigned.
In a choppy market, selling put options generates income in the form of premiums. You may also be rewarded with the opportunity to purchase shares down the road at a better-than-market price.
This technique is best used when you have an interest in purchasing the underlying shares anyway.
Avoid Buying Options
Buying options is not a recommended strategy in a choppy market. You are unlikely to generate measurable returns, because time decay will erode the value of your options.
Essentially, as the options’ expiration dates come closer, there is less time available for the market to make a move.
The premium drops and your contracts are worth less – and if they expire out of the money, they are worth nothing at all. This is a risky position to be in when the market is choppy.
How To Trade A Choppy Market: The Bottom Line
Some investors say it is not possible to profit during a choppy market, but that simply isn’t true.
While standard investment strategies may not be right for these circumstances, you can successfully trade a choppy market by adjusting your methods.
If you have the time, discipline, precision, and patience, you can try to buy the lows and sell the highs. Otherwise, consider covered calls, high dividend stocks, and selling put options on stocks you want to buy.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.