Investment Strategies for Extremely Volatile Markets

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.

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.

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.

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.

The Bottom Line

The first thing to do in a turbulent market is to step back and examine your purpose for investing. It's hard not to panic when the market goes down or to become an ostrich and do nothing, but neither furthers your goals. Market volatility offers more opportunities to profit in a short amount of time, but it also brings more risk.