How to Invest in Times of High Volatility

Is volatility the enemy of investors? Not necessarily. There are various strategies and financial instruments which can help you protect your wealth or even profit from volatility.

The term volatility is often used as a synonym for a risk of loss. The impression that gives is that high volatility is always bad for investors. But that is not the truth. Volatility presents both a risk of loss and an opportunity for gain. For investors with a long-term investment horizon, volatility does not normally present a problem. If you buy and hold a security, you do not need to worry about short-term volatility.

High volatility during downward trends

The biggest price movements are usually caused by market insecurities, but correlations between falling prices and volatility may also occur. Drops in stock market prices are normally much sharper than upward movements. That means losses occur over a shorter timeframe than gains. So volatility is normally higher when prices fall. You can find out how you as an investor can respond to a market collapse in this guide.

It is important to keep a level head when investing in volatile markets, and during times when the value of your securities fluctuates strongly. Here, moneyland.ch lists techniques which you can use to protect your wealth or even profit from volatility:

• Swing trading

When markets experience drastic upward and downward turns, investors can try to profit from the daily fluctuations by placing limit orders with their stock brokers, or by monitoring the market and buying and selling at the right time. This strategy is sometimes called swing trading. Assets are often bought and sold on the same day, in which case the term day trading is often used.

The idea behind swing trading us that you buy an asset at a certain price and then use a limit order to set a threshold for the price at which you are willing to sell it. If and when the price meets or surpasses the limit, the asset is sold at the limit price, or higher. The skill is knowing where to set the threshold so that it the price will actually reach that limit with the going volatility – even if you do not expect the price to remain that high for long.

Theoretically, you can use this process over and over again to earn ongoing returns. You buy an asset every time its value falls below a certain price, and you sell it every time it climbs above a certain threshold.

The problem with this strategy is that it is not supported by fundamental values. Whether or not the plan works out is entirely dependent on volatility driving the low enough and high enough. Prices may also remain stagnant, or move in the wrong direction. Frequent buying and selling also generates much higher costs than a buy and hold strategy, and only works if you are able to buy and sell at the right time.

• Volatility indexes

There are a number of indexes which indicate current and future volatility in markets. The best-known of these is the VIX index, also referred to as the fear index. It indicates the volatility of the S&P 500. Volatility on the Swiss SMI index is tracked by the VSMI, for example, while the volatility index for the largest European companies is VSTOXX.

Investors can use special financial products to invest in these indexes. This can be done using futures and options, for example. But the selection of products available to private investors in Switzerland is still relatively small, and consists mostly of VIX-based products.

When volatility increases, the corresponding volatility index goes up too. The result is that these indexes often shoot up during major price corrections or even market crashes. For this reason, derivatives based on volatility indexes are primarily used for hedging a portfolio against major losses caused by sharp downward movements.

• Options

If you expect to see major spikes and dives in markets, you can use options to take advantage of these big price movements. Options are primarily beneficial in the event that the price of the underlying asset changes suddenly and in a big way. This kind of volatility can even occur in times when the market as a whole is very stable.

This strategy demands that you the option you buy or sell matches the movements in the market. Buying a put option only pays off if the price of the underlying asset falls by a substantial amount. If the price goes up, the put option will not benefit you. Whether you can sell the underlying asset at any time (American option) or only after a fixed term (European option) is another important factor.

Options are not normally suitable for inexperienced investors because they are relatively complicated. Trading with options can also be expensive, particularly during periods when market volatility is already rated as high. This strategy only works if the actual volatility turns out to be higher than the implied volatility priced into the option when it is created.

• Volatility Swaps

Investors can use so-called volatility swaps to bet on the future volatility of an underlying value (a stock or a whole index, for example) directly. It makes no difference whether the price of the asset goes up or down. The only thing that matters is the size of the changes in its price.

The key factor for these financial products is whether the actual volatility is higher or lower than the implied volatility. Here is a simplified example: An investor buys a volatility swap base on the SMI with a one-year term and a value of 1000 francs. At the time that the option is issued, the implied volatility of the SMI for the coming 12 months is 10 percent. The SMI’s actual volatility over the one-year term turns out to be 15 percent. Because volatility was 5 percent higher than expected, you earn a 50-franc return (5 percent of 1000 francs). If, on the other hand, volatility on the SMI were just 5 percent, you would have lost 50 francs.  

Volatility swaps are traded over the counter. The name is a misnomer, because they are in fact forwards and not swaps. A variance swap, on the other hand, is a genuine swap. Variance swaps are very similar to volatility swaps and accomplish much the same task.

The exact functions of these derivatives vary from case to case. In many cases, calculating gains and losses can be much more complicated than the example above. Because of their complexity, they are not suitable for inexperienced investors.

• Volatility arbitrage

Volatility arbitrage is a strategy employed in options trading with which investors speculate on the volatility of an underlying asset rather than its price. This is accomplished by combining a long and a short position. Example: You buy a call option with implied volatility that is lower than what you expect to see over the option term. You then open a short position on the same asset underlying the call option (by short-selling it, for example), so that both positions correspond.

The balance between the long position (the call option) and the short position is maintained by so-called delta hedging. Both positions always remain perfectly balanced, even when the price of the underlying asset changes. In the above example, that would mean making additional short sells if the price of the underlying asset goes up, and buying additional call options if the price goes down. In this way, you can earn small returns if prices fluctuate strongly and frequently (you sell when prices are high and buy again when prices are low). If prices hardly change, or do not change at all, then you make a loss equal to the premium which you pay for the option.

The advantage of this strategy is that you can gain whether the value of the underlying asset rises or falls. Instead, successful volatility arbitrage requires being able to predict volatility better than the rest of the market does. If you do not, you may make losses instead of returns. Delta hedging also generates costs which cut into possible profits.

The disadvantage is that volatility arbitrage can only deliver ongoing returns when markets are relatively stable. Extreme insecurity in markets can result in losses. This strategy only pays off if the market as a whole is somewhat constant, and even then, the returns are moderate.

• Short positions

Because high volatility often occurs when markets are on a downward trend, short selling can be more advantageous during these periods. If the price of the shorted security falls, you can buy it back for less than you sold it for, pocketing the difference.

For this strategy to be successful, the price of the underlying asset has to fall after you open the position. If that does not happen, you cannot profit from the short position. Volatility alone is not sufficient – the price has to move downwards. If volatility results in the price bouncing up and down, then using long positions to catch the upward movements instead can deliver higher returns because short-selling generates costs. The longer you hold a short position, the higher the costs are.

Many analyses of historical data show that short selling tends to aggravate market volatility. When investors use short selling to profit from volatility, they are in fact making the markets even more volatile.

Hedging against losses

Financial instruments based on volatility are normally used to hedge against unexpected losses. Many longstanding strategies like diversification and cost averaging can also be used to help minimize the risks posed by volatile securities.

More on this topic:
How to invest during a stock market crash
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