Most investors are aware that the market undergoes periods of both bull runs and downturns. So what happens during periods of extreme market volatility? Making the wrong moves could wipe out previous gains and more.
By using either non-directional or probability-based trading methods, investors may be able to protect their assets from potential losses and may be able to profit from rising volatility using certain strategies.
Key Takeaways
- In financial markets, volatility refers to the presence of extreme and rapid price swings.
- Given increasing volatility, the possibility of losing some or all of an investment is known as risk.
- Directional investing, a strategy practiced by most private investors, requires the markets to move consistently in the desired direction.
- On the other hand, non-directional investing takes advantage of market inefficiencies and relative pricing discrepancies.
- Volatility allows investors to reconsider their investment strategy.
Volatility vs. Risk
It’s important to understand the difference between volatility and risk before deciding on a trading method. Volatility in the financial markets is the quantification of the speed and magnitude of an asset’s price swings. Any asset that sees its market price move over time, has some level of volatility. The greater the volatility, the larger and more frequent these swings are.
Risk, on the other hand, is the possibility of losing some or all of an investment. There are several types of risk that can lead to a potential loss, including market risk (i.e., that prices will move against you).
As the volatility of the market increases, market risk also tends to increase. In response, there can be a marked increase in the volume of trades during these periods and a corresponding decrease in the holding periods of positions. In addition, hypersensitivity to news is often reflected in prices during times of extreme volatility as the market overreacts.
Thus, increased volatility can correspond with larger and more frequent downswings, which presents market risk for investors. Luckily, volatility can be hedged away to some degree. Moreover, there are ways to actually profit directly from volatility increases.
Hedging Against Volatility
Perhaps the most important thing for most long-term investors is to hedge against downside losses when markets turn volatile. One way to do this, of course, is to sell shares or set stop-loss orders to automatically sell them when prices fall by a certain amount. This, however, can create taxable events and, moreover, removes the investments from one’s portfolio. For a buy-and-hold investor, this is often not the best course of action.
Instead, investors can buy protective put options on either the single stocks they hold or on a broader index such as the S&P 500 (e.g., via S&P 500 ETF options). A put option gives the holder the right (but not the obligation) to sell shares of the underlying as a set price on or before the contract expires. Say that XYZ stock is trading at $100 per share and you wish to protect against losses beyond 20%. You can buy an 80 strike put, which grants the right to sell shares at $80, even if the market falls to, say, $50. This effectively sets a price floor.
Note that if the stock never falls to the strike price by its expiration, it will simply expire worthless and you would lose the premium paid for the put.
Trading Volatility
Investors who wish to take a directional bet on volatility itself can trade ETFs or ETNs that track a volatility index. One such index is the Volatility Index (VIX) created by CBOE which tracks the volatility of the S&P 500 index. Also known as the “fear index,” the VIX (and related products) increase in value when volatility goes up.
You may also consider buying options contracts to profit from rising volatility in addition to hedging your downside. Options prices are closely linked to volatility and will increase along with volatility. Because volatile markets can lead to swings both upwards and downwards as prices gyrate, buying a straddle or a strangle are popular strategies. These both involve simultaneously buying a call and a put on the same underlying and for the same expiration. If prices move a great deal, either strategy can increase in value.
Because of the way VIX exchange-traded products are constructed, they are not intended to be long-term investments. Rather, they are meant to make short-term bets on volatility changes.
Non-Directional Investing
Most investors engage in directional investing, which requires the markets to move consistently in one direction (which can be either up for longs or down for shorts). Market timers, long or short equity investors, and trend followers all rely on directional investing strategies. Times of increased volatility can result in a directionless or sideways market, repeatedly triggering stop losses. Gains earned over years can be eroded in a few days.
Non-directional equity investors, on the other hand, attempt to take advantage of market inefficiencies and relative pricing discrepancies. Importantly, non-directional strategies are, as the name implies, indifferent to whether prices are rising or falling, and can therefore succeed in both bull and bear markets.
Equity-market-neutral strategy
The principle behind the equity-market-neutral strategy is that your gains will be more closely linked to the difference between the best and worst performers than the overall market performance—and less susceptible to market volatility. This strategy involves buying relatively undervalued stocks and selling relatively overvalued stocks that are in the same industry sector or appear to be peer companies. It thus attempts to exploit differences in those stock prices by being long and short an equal amount in closely related stocks.
Here is where stock pickers can shine because the ability to pick the right stock is just about all that matters with this strategy. The goal is to leverage differences in stock prices by being both long and short among stocks in the same sector, industry, nation, market cap, etc.
By focusing on pairs of stocks or just one sector and not the market as a whole, you emphasize movement within a category. Consequently, a loss on a short position can be quickly offset by a gain on a long one. The trick is to identify the standout and the underperforming stocks.
Merger arbitrage
The stocks of two companies involved in a potential merger or acquisition often react differently to the news of the impending action and try to take advantage of the shareholders’ reaction. Often the acquirer’s stock is discounted while the stock of the company to be acquired rises in anticipation of the buyout.
A merger arbitrage strategy attempts to take advantage of the fact that the stocks combined generally trade at a discount to the post-merger price due to the risk that any merger could fall apart. Hoping that the merger will close, the investor simultaneously buys the target company’s stock and shorts the acquiring company’s stock.
Relative value arbitrage
The relative value approach seeks out a correlation between securities and is typically used during a sideways market. What kinds of pairs are ideal? They are heavyweight stocks within the same industry that share a significant amount of trading history.
Once you’ve identified the similarities, it’s time to wait for their paths to diverge. A divergence of 5% or larger lasting two days or more signals that you can open a position in both securities with the expectation they will eventually converge. You can long the undervalued security and short the overvalued one, and then close both positions once they converge.
What Causes Market Volatility?
In general, market volatility increases when there is greater fear or more uncertainty among investors. Either can result from an economic downturn or in response to geopolitical events or disasters. For instance, market volatility rose due to the credit crisis in 2008-09 that led to the great recession. It also spiked when Russia invaded Ukraine in 2022.
What Investments Track the VIX Volatility Index?
Futures on the VIX trade on the CBOE and are available to customers of some brokerages. For those who do not have access to futures, there are also ETFs and ETNs, including the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX), iPath Series B S&P 500 VIX Mid-Term Futures ETN (VXZ), and ProShares VIX Short-Term Futures ETF (VIXY).
What Is Probability Based Investing?
In addition to hedging, one can also look to fundamental analysis to understand the risk of an individual stock. Even with liquid and pretty efficient markets these days, there are times when one or more key pieces of data about a company are not widely disseminated or when market participants interpret the same information differently. That can result temporarily in an inefficient stock price that’s not reflected in its beta. Holders of that stock are, therefore, implicitly taking on additional risk of which they are most likely unaware.
Probability-based investing is one strategy that can be used to help determine whether this factor applies to a given stock or security. Investors who use this strategy will compare the company’s future growth as anticipated by the market with the company’s actual financial data, including current cash flow and historical growth. This comparison helps calculate the probability that the stock price is truly reflecting all pertinent data. Companies that stand up to the criteria of this analysis are therefore considered more likely to achieve the future growth level that the market perceives them to possess.