Trading in an Uncertain Market

Volatility is a trader's bread and butter: Without it, profits are harder to come by. However, when volatility remains elevated for an extended period—as it has this year—it could be the sign of a more deeply rooted market shift.

For many traders, that may mean adopting a more defensive approach, lest the promise of price swings turn into too much of a good thing. Here are three tips for trading in an uncertain market.

I've closed out most of my speculative positions in favor of more conservative trade candidates. That meant replacing heavily promoted cash-burning upstarts that lacked the ability to weather a tough market with more stable companies that have strong cash flows and competitive positions. That way, I can ride out a potential bear market knowing the companies I own will most likely still be around.

Those looking to follow suit can use Schwab's screening tool to search for companies by the following characteristics:

• Volume: Stocks with higher trading volumes tend to be less volatile than lower-volume stocks because it takes a lot more trading activity to move their prices.
• Price per share: Shares priced in the double digits or higher tend to be less volatile than cheaper stocks because, as with volume, it takes proportionally more movement to affect them. Stocks with solid share prices also are less likely to be delisted for failing to meet their exchanges' minimum price requirements.
• CFRA rating: CFRA, one of the world's largest independent investment research firms, rates 5,000 publicly traded stocks based on certain fundamental factors. Stocks with a three-star rating are expected to perform in line with their benchmarks over the next 12 months, while those rated four or five stars are expected to beat their benchmarks.
• Schwab Equity Rating: Schwab's scoring system—which analyzes stocks based on growth, quality, sentiment, stability, and valuation criteria—awards an A rating to just 10% of the qualifying stocks. Our research shows that A-rated stocks, on average, strongly outperform the market because the grade consistently captures companies with low and potentially improving investor expectations, which generally coincide with a stock's price trending upward.
   

Once you have a list of higher-quality stocks to consider, you can employ additional filters based on the current environment. For example, you may wish to:

• Adjust for price volatility: Established companies with strong fundamentals tend to be more stable, but they also tend to experience smaller price swings—making it more difficult to realize short-term profits. If you're looking for more stability but don't want to become stuck in a tight trading zone, consider filtering out companies with low levels of price volatility. Just be sure to keep your eye on what's happening in the broader market, as trading higher-volatility stocks at a time when the market is already roiling can open you up to bigger losses.
• Check the timing: Determining the ideal time to open a new position is one of the most difficult aspects of trading, especially during a volatile market when price patterns are harder to identify. In such environments, a useful tool is a stock's MarketEdge Second Opinion^® report, which uses a combination of technical indicators to determine whether a stock might trend higher over the next 60 to 90 days (a "Long" opinion), trade sideways in the near term (a "Neutral" opinion), or trade lower over the next 30 to 60 days (an "Avoid" opinion).

During challenging trading environments, I'll often reduce the collective size of my positions from 20% of my total investable assets to 15% or even 10%. I might also limit the size of any one position to no more than 5% of my total assets.

However, focusing on quality stocks may still allow you to generate some tidy profits while reducing your overall risk in the event the market moves lower.