How to Use Market Volatility to Your Advantage
Editor’s Note: Today, we’re bringing back our friend and colleague Marc Lichtenfeld of Wealthy Retirement.
He’s here to tell us how investors can use market volatility to hedge their portfolios or trade for profits.
– Kaitlyn Hopkins, Assistant Managing Editor
When the market crashed in March, a lot of attention was paid to volatility.
Market volatility is the variation of a trading price over time.
The most common way to measure the variation of the price of the broader market is the CBOE Volatility Index, or VIX. It measures option prices on the S&P 500.
Volatility is also a tool that you can use to hedge your portfolio or trade for profits.
For example, when volatility was low last winter, many traders and investors bought calls on the VIX or other volatility instruments as hedges. That way, if volatility spiked (usually causing stock prices to go lower), those who owned calls would offset losses in their stock portfolios or profit in a short-term trade.
The VIX is a sentiment indicator. When it’s high, investors are fearful. When it’s low, they’re complacent.
When the market crashed in March, the VIX soared to its highest level since the financial crisis of 2008. An astute investor may have seen this as a sign of panic and that the market was likely to stop falling.
In fact, it did. The market bottomed a week later.
Traders who don’t want to deal with company earnings reports, reactive CEO tweets, or analyst upgrades and downgrades can just trade volatility on the indexes.
That way, the only thing that matters is whether volatility goes up or down. It simplifies the trading process, and the trader has to follow only one index.
There are various ways to trade volatility. You can trade options on the VIX or use a variety of exchange-traded funds (ETFs) that are based on the VIX. Some are leveraged and move more or less than the VIX in some specific proportion, like 1.5 times. There are inverse VIX ETFs that move in the opposite direction of the index. You can also trade options on these ETFs.
Another way to use volatility is to trade options on stocks or other indexes.
When volatility is high, you may want to consider selling options because high volatility makes option prices expensive. So you could sell puts or calls and capture a significant premium.
When volatility is low, you may look to buy puts or calls because the options should be cheap.
Right now, volatility is slightly above the historical average, but it has come way down from previous highs. Though the market is strong now, it makes sense to position yourself for higher volatility in the near term. There are so many risks out there, including economic data, health concerns and politics. I expect volatility to increase again in the near future.
What’s interesting to me about trading volatility is that you’re not trying to predict which way the market will go… You’re trying to predict how investors will behave.
And, historically, investor emotions have been somewhat predictable…
Fear is usually the greatest right near market bottoms, and confidence is at its highest near market highs.
You can bet on those widely held emotions and hedge your portfolio or make some big profits without buying a single share of stock. You just need to invest in volatility.