Most investors are aware that the market has both bull runs and bear markets. So, what happens when the market is really volatile? Making the incorrect choices might result in the loss of all prior profits and more.
Investors may be able to safeguard their assets from possible losses and benefit from growing volatility by employing either non-directional or probability-based trading approaches.
- Volatility in financial markets refers to the existence of significant and quick price movements.
- Risk is the danger of losing part or all of an investment due to rising volatility.
- Most private investors use directional investing, which needs markets to move continuously in the desired direction.
- Non-directional investment, on the other hand, takes advantage of market inefficiencies and price disparities.
- Volatility gives investors the opportunity to reassess their investing approach.
Volatility vs. Risk
Before settling on a trading strategy, it’s critical to grasp the distinction between volatility and risk. In the financial markets, volatility is defined as the pace and size of an asset’s price movements. Volatility exists in any asset whose market price changes over time. The higher and more frequent these fluctuations are, the greater the volatility.
The danger of losing part or all of an investment, on the other hand, is referred to as risk. Market risk is one of various forms of risk that might result in a possible loss (i.e., that prices will move against you).
Market risk tends to grow in tandem with market volatility. As a result, there may be a noticeable rise in trading volume during certain times, as well as a corresponding drop in position holding durations. Furthermore, during times of excessive volatility, hypersensitivity to news is typically reflected in prices as the market overreacts.
As a result, heightened volatility might result in bigger and more frequent downswings, posing market risk to investors. Fortunately, volatility may be mitigated to some extent. Furthermore, there are methods to benefit directly from increased volatility.
Hedging Against Volatility
The most essential thing for most long-term investors is to protect themselves from losses when markets get turbulent. Of course, selling shares or setting stop-loss orders to automatically sell them when prices fall by a specific amount is one approach to do this. This, however, might result in taxable events as well as the removal of the assets from one’s portfolio. This is often not the greatest strategy for a buy-and-hold investor.
Instead, investors may purchase defensive put options on individual equities or on a wider index such as the S&P 500. (e.g., via S&P 500 ETF options).A put option grants the holder the right (but not the responsibility) to sell shares of the underlying at a predetermined price on or before the contract’s expiration date.
Assume XYZ stock is trading at $100 per share and you want to protect yourself against losses greater than 20%. You may purchase an 80 strike put, which gives you the option to sell shares for $80 even if the market falls to, say, $50. This basically establishes a price floor.
It is important to note that if the stock does not fall to the strike price by the expiry date, it will simply expire worthless, and you will lose the premium paid for the put.
Investors who want to wager on volatility may do so by purchasing ETFs or ETNs that follow a volatility index. The CBOE Volatility Index (VIX), which monitors the volatility of the S&P 500 index, is one such index. The VIX (and similar instruments), sometimes known as the “fear index,” rise in value as volatility rises.
In addition to hedging your downside, you may want to explore purchasing options contracts to benefit from growing volatility. Options pricing are tightly connected to volatility and will rise in tandem. Because unpredictable markets may produce price swings both upwards and downwards, purchasing a straddle or a strangle is a common strategy. Both entail purchasing a call and a put on the same underlying asset for the same expiry date. If prices fluctuate dramatically, each technique has the potential to gain in value.
VIX exchange-traded funds are not meant to be long-term investments because to the way they are designed. They are designed to make short-term bets on volatility fluctuations.
Most investors participate in directional investing, which necessitates that markets constantly move in one direction (which can be either up for longs or down for shorts).Directional investing tactics are used by market timers, long or short stock investors, and trend watchers. During times of high volatility, the market might become directionless or sideways, triggering stop losses frequently. Gains made over many years may be wiped out in a matter of days.
Non-directional equity investors, on the other hand, seek to profit on market inefficiencies and price disparities. Non-directional methods, as the name indicates, are unconcerned with whether prices are increasing or decreasing, and may therefore thrive in both bull and down markets.
The underlying idea of the equity-market-neutral approach is that your returns will be more directly related to the differential between the best and worst performers than than the overall market performance—and therefore less sensitive to market volatility. This technique entails purchasing inexpensive stocks and selling overpriced stocks in the same industrial area or that look to be peer firms. It so aims to profit from variations in stock prices by holding an equal number of long and short positions in closely connected equities.
This is where stock pickers may flourish, since the ability to choose the appropriate stock is all that counts in this method. The idea is to capitalize on price disparities across companies in the same sector, industry, country, market value, and so on.
You accentuate movement within a category by concentrating on pairs of stocks or just one sector rather than the market as a whole. As a result, a short position loss may be immediately compensated by a long position gain. The goal is to identify the outliers and underperformers.
Stocks of two firms engaged in a proposed merger or acquisition frequently respond differently to news of the imminent move and attempt to capitalize on the shareholders’ response. Frequently, the stock of the acquirer is discounted, while the stock of the firm to be purchased increases in anticipation of the acquisition.
A merger arbitrage strategy seeks to capitalize on the fact that the merged equities often trade at a discount to the post-merger price owing to the chance that any merger may fail. In the hope that the merger would go through, the investor buys the target company’s shares while shorting the acquiring company’s stock.
Relative Value Arbitrage
The relative value strategy looks for correlations between assets and is most often utilized in a sideways market. What kind of couples are ideal? They are both heavyweight equities in the same industry with extensive trading histories.
Once you’ve recognized the parallels, you must wait for their courses to separate. A 5% or greater dispersion that lasts two days or longer indicates that you may initiate a trade in both equities with the assumption that they will ultimately converge. You may take a long position in the undervalued security and a short one in the overpriced asset, then close both positions once they converge.
What Causes Market Volatility?
In general, market volatility rises as investors become more fearful or unsure. Either might occur from an economic slowdown or from geopolitical events or natural calamities. For example, market volatility increased as a result of the financial crisis in 2008-09, which contributed to the Great Recession. It also increased significantly when Russia invaded Ukraine in 2022.
What Investments Track the VIX Volatility Index?
The VIX futures contract is traded on the CBOE and is offered to clients of certain brokerages. There are additional ETFs and ETNs for people who do not have access to futures, such as the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX), the iPath Series B S&P 500 VIX Mid-Term Futures ETN (VXZ), and the ProShares VIX Short-Term Futures ETF (VIXY).
What Is Probability Based Investing?
In addition to hedging, fundamental analysis may be used to understand the risk of a certain asset. Even in today’s liquid and somewhat efficient markets, one or more critical pieces of information about a firm may not be broadly communicated, or market players may interpret the same information differently. This may result in an inefficient stock price that is not represented in the beta. Holders of such stock are thereby tacitly accepting more risk, most often ignorant of it.
One approach that may be used to assist identify whether this element applies to a certain company or investment is probability-based investing. This technique requires investors to compare the company’s expected future growth with the company’s actual financial data, which includes current cash flow and previous growth. This comparison helps in calculating the likelihood that the stock price accurately reflects all relevant facts. Companies that meet the criteria of this study are consequently seen to be more likely to attain the market-perceived future growth level.
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