Make Market Volatility Work for You - dummies

By David Stevenson

Investors are timid creatures, despite their protestations to the contrary. The language of financial markets in the UK and around the world may feature muscular terms such as rampaging bulls and ravenous bears, but in reality investors fight shy of too much change in the market measured by share-price volatility (that is, their movement up and down on a real-time and daily basis).

This is despite the fact that investors can’t possibly hope to make a super-sized return of, say, 20 or even 50 per cent by investing in shares unless they’re willing to lose this much or even more on the downside.

But in recent years many mainstream investors decided that the potential for great losses is just too miserable to contemplate. Risk has been taken off the table globally and investors switched en masse from stocks and shares to supposedly less risky assets such as bonds or even cash.

The fact is that markets are volatile; sometimes more so, other times less so. And shares are inherently volatile, which means that they’re risky. But that variance is precisely what makes them attractive. This volatility is in fact a major source of their superior return over the long term. Investors hope that upside days more than compensate for the down days.

Don’t always be terrified of very volatile markets. Volatility can represent enormous opportunity if you’re clever enough to work out where the markets go next. But when markets are highly volatile, take care and keep a buffer of cash in place.

Accept the reality of volatility: It constantly changes!

Risk as measured by the term volatility is, by definition, constantly changing — investments based on an index that uses forward-looking options is never going to be a boring process and that change in pricing offers investors some specific opportunities. Most investors (correctly) think of volatility as inherently dangerous, but volatility as an asset class on its own can be profitable if you’re willing to be tactical.

Although most investors rightly tend to steer away from volatile stocks, that doesn’t mean that you can’t make money as a trader from investing in volatility indices such as the VIX.

Volatility in the American S&P 500 market index is measured using the VIX options-based index and other instruments and is also trackable by all manner of financial instruments. These funds, notes and products can go up and down in value on a daily basis and investors can build a successful tactical strategy around these changes.

Even longer-term investors can use volatility within their portfolios, through intelligent use of structured investments as part of a strategy that deliberately looks to diversify between different assets.

UK stocks have an equivalent volatility index (the VFTSE) and the European one is called the VSTXX. Through these different indices, you can in a sense ‘invest’ in volatility and look upon it as yet another asset class. In fact, it can be an excellent hedge for equity-focused investors. Many professional investors watch the VIX, VFTSE and VSTXX indices carefully.

Avoid volatility as a distinct asset class unless you’re willing to understand it, examine how it’s measured and tracked, and discover how you can use it tactically.

Measure volatility

The daily increase or decrease in the price of an asset — bond or share — is measured through its variance, a statistical term that measures the underlying volatility of an asset.

Imagine two otherwise similar stocks over a month period in which both start and end at the same price — stock A moves up and down by an average of 2 per cent every day for a month, whereas Stock B changes by 10 per cent every day for a month. Both shares started and ended the period at the same price but Stock B is more volatile.

Investment analysis suggests that, if Stock B stays more volatile for extended periods of time, eventually its returns will probably be negative whereas Stock A’s returns should prove positive, especially with dividends included. Yet volatility is rarely that predictable — many stocks move through phases when they’re intensely volatile and then ‘settle down’, with a subsequent decline in volatility.

What’s true for Stocks A and B in the example is also true for indices such as the S&P 500. These big, well-known indices go through periods of high volatility (usually inspired by fear) and then longer bouts of relative calm (where volatility on a daily basis ebbs away).