How the Pros Ride Market Volatility — and Why You Shouldn’t
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The stock market this year has strapped investors onto a roller-coaster ride filled with stomach-heaving drops and exhilarating highs. In spring, fears surrounding the coronavirus helped send the benchmark S&P 500 on a 34% drop from its prior peak. Since then, there have been a number of single-day-record point losses and gains, and in August, fueled by optimism over the world’s ability to manage the pandemic, the index crested to an all-time high.
Seasoned stock traders often deploy high-risk strategies to cash in on the twists and turns. As the coronavirus lockdowns have seen an increase in amateur investors entering the market, experts warn that these volatility plays are not a ride for the average investor.
"Taking advantage of volatility requires an intrinsic understanding of economic cycles and examination of raw data. Once the trend hits the market, you have missed the train," says Simon Calton, CEO of the Carlton James Group, a private investment group based in London. "Even amongst experienced investment managers, huge sums of money can be lost."
The ‘fear’ barometer
While the S&P 500 clocked historic point drops, the Chicago Board Options Exchange Volatility Index (VIX) was hitting record highs. Also known as the "fear index," the VIX calculates a number based on where investors think the market is headed the next month: The higher the VIX index number, the more likely investors expect stock price volatility.
On March 16, the VIX index hit a record closing high of 82.69, eclipsing figures set in 2008 during the Great Recession. By comparison, the VIX was 12.47 on the first trading day of 2020.
The VIX's volatility projection is derived specifically from options on the S&P 500. Options trading involves bets on which direction a particular stock will go — up or down — and contracts to buy or sell that stock at a pre-negotiated price by a set date.
For options traders, big movements can set the stage for big gains. And investors can trade options on the direction of the VIX itself, making a bet on whether the market will become more or less volatile.
"Today a lot of retail investors especially will utilize leveraged volatility ETF funds to take advantage of this strategy," says Daniel Milan, managing partner of Cornerstone Financial Services in Southfield, Michigan.
But unlike most exchange-traded funds, these funds are purchased with debt and should be held only for a limited period of time, experts say, and are not part of the buy-and-hold strategy favored by many investors.
"Volatility trading can be complex, and it is not something an inexperienced trader should attempt," says Charles Sizemore, a registered investment advisor and portfolio manager for online broker Interactive Advisors.
Best volatility move: diversification
Experts agree that for most investors, diversifying your portfolio across a variety of assets is the strongest protection when markets get turbulent.
"The best and easiest way to protect yourself from volatility is simply to diversify," Sizemore says. "Keeping a larger percentage of your portfolio in bonds or cash will reduce your portfolio volatility and give you the firepower to buy any dips."
Besides investing in stocks, bonds and related funds, having some investments that don’t typically mirror wider stock market moves — such as commodities, currencies or real estate investments — can help diversify, experts say.
"Non-correlating assets react differently to changes in the markets compared to stocks — often, they move in inverse ways," Milan says. "When one asset is down, another is up. So, they smooth out the volatility of a portfolio's worth overall."
Another strategy is using dividend-paying stocks, mutual funds and ETFs. "Owning stable companies that pay dividends is a proven method for delivering above-average returns," Milan says.
Keeping your portfolio diversified and periodically rebalancing to ensure you have the right mix of assets is the best hedge against volatile markets, Sizemore adds. "It's not sexy or exotic. But it's solid advice," he says.