You simply adjust your trading style to the market you are trading in. The how is really dependant on the preferences and needs of each individual trader. For me, it comes down to my overall philosophy: the market may be unpredictable but the people who are trading the market are predictable.
Compare the two charts below, VIX and SPY.
During the month of April, VIX is channeling and remains relatively low and then the last 5 days, it starts to increase. Compare that to the SPY chart and you will see when VIX is stable, we have the standard BTFD trend trading. Once volatility increases you will see the SPY start to drop.
Also, notice the duration of those two stages. The long trend then a quick steep reaction.
From a psychological standpoint, the smart money will follow the standard buy low volatility sell high volatility motto. Dumb money will be the ones pushing against this trend causing chaos/spikes. You can typically tell the difference based on volume and impact to price action.
Smart money will increase the volume significantly but keep the price consistent so they can get in and out without losing too much at each end of the trade. Dumb money will be lower volume and will impact price significantly.
To bring that back to an analogy standpoint, when volatility increases, the smart money is like this slow moving avalanche that is coming down the mountain, stopping for a drink at every chateau to keep the buzz going. Dumb money steps in front of the avalanche and tries to distract it by doing the Humpty Dance. It works for a second until the avalanche realizes their leg is not actually broken.
There are a few insights here:
1 – You can use volatility to help you determine the direction of the market
2 – Looking at things like direction, volume, and price action, you can tell who is in the market and when
3 – Once volatility increases, the market tends to gap up or down on both the market open and close, meaning you need to shorten your trade duration
Using these insights you can easily start to craft a strategy that will work for whatever trading needs you have. In my case, if I see smart money moving, I will hold longer than I will if I see dumb money. Depending on the direction, I will either go with the flow or counter trend trade.
On 5/2 we had an increase in volatility and a $2 drop from an ATH. Because we have been in a long term bullish trend, dumb money would think that this was a standard pull back and it is a BTFD opportunity. Smart money would wait to see what happens.
On 5/3 once volatility drops, I went long with a call option and once we could not make it back to that ATH number, I was out for a quick 30% move. I aligned my trading style with dumb traders in order to tack advantage of the increase in volume/momentum but made sure to get out selling into their strength.
If we were able to make it back to that ATH point, I would have held at least another day to see if it could stay above that level.
On 5/6 the next trading day, volatility spiked, and we saw an interesting battle of smart money offloading shares while dumb money was buying it all up, which drove the price upwards. It was a bit of panic on both sides so I sat out and waited to see what happened on 5/7.
5/7 volatility increased again, price action gapped down, so I went with a put option this time once the direction was confirmed. Waiting for confirmation here is key because it could have just been an opening market panic sell. We stalled a bit in the afternoon and I took my 30% and walked away. Good thing because like usual we see a huge drop EOD.
So to sum up:
1 – Use the data in front of you to figure out the direction, who you are working with and opportunity
2 – Volatility is actually your friend because you will have larger movements within a quicker time frame and how it moves tells you were the money is going to go
3 – You need to be able to trade both ways to really take advantage of opportunities as they arise
4 – Decrease your duration and take your money off the table as soon as the trend starts to stall. Most of the time for me, this means day trading instead of holding anything overnight.
5 – Dont have a bias. Let the money tell you were to go
6 – Its ok to follow the dumb money as long as you know where the gaps in their trading are you can take advantage of
7- Smart money is also slow money so they may not react fast enough for your money