Trade The Journey

Trade The Journey

Navigating market volatility: Investment strategies for uncertain times

What is volatility? If you watch the financial news, you’ll hear market pundits, analysts, and guests talking about volatility in the market. The most common metric used to gauge the market’s volatility is the VIX. Although each of the indices has a volatility index, the one the market typically focuses on is the VIX, which tracks the S&P 500.

The VIX was created by Robert Whaley. In a paper he wrote entitled, “Understanding the VIX” he defined the VIX as:

A forward-looking index of the expected return volatility of the S&P 500 Index over the next 30 days is implied from the prices of S&P 500 index options, which are predominantly used by the market as a means of insuring the value of stock portfolios. High levels of the VIX reflect investor anxiety regarding a potential drop in the stock market.

Helpful notes from the article:

  • VIX intended to provide a benchmark of expected short-term volatility and an index upon which futures and options contracts on volatility could be written.
  • Over time the VIX changed from tracking eight at-the-money options for the S&P 100 index options to tracking the new more active S&P 500 index options.
  • A change occurred in the VIX as S&P 500 at-the-money and out-of-the-money options began to be brought by portfolio managers for downside protections.
  • The VIX is mean reverting, as it returns to its average.
  • Market Anxiety is gauged by looking at the persistence with which the VIX remains above certain extraordinary levels.
  • Volatility measures the unexpected market moves either up or down although it has become known as the fear index.
  • If expected market volatility increases (decreases), investors demand higher (lower) rates of return on stocks, so stock prices fall (rise).

Normally as the VIX is ticking up, the S&P 500 is trending downwards. Downtrends are fast and painful in contrast to uptrends. However, there are a few times when the VIX rose as the market headed higher.

Another way to think about volatility is the amount of emotion in the market in terms of pain and worry. Listen to the market because it’s always right regardless of what you or I think. If there’s a lot of fear in the market, astute investors should be prepared to invest at bargain prices.

There are many ways to think about volatility and it could be said that with so many descriptions of volatility, the true meaning of volatility is still being defined. But that doesn’t mean we can use volatility to our benefit. One important thing to state is that VIX as well as implied volatility often overstates the amount of volatility expected. This can be examined by looking at the historical volatility which shows the actual volatility.

I included the calculation used to find the VIX below:

It’s a good thing that you and I don’t have to calculate the VIX to anticipate the future volatility for the next thirty days.  I won’t get too much into options as it is a complicated type of trading or investment option.

Buying an option gives you the right but not the obligation to take control of 100 shares for an equity option. When you pay a premium, that gives you control of 100 shares of stock for however long you have purchased the option. You can purchase an option with an expiration date of days, weeks, months, or years. Selling an option entitles you to receive a premium but you are obligated to deliver the shares if you are called.

Market participants purchase options for various reasons, for some it’s a hedging tool and for others, it’s a way to use leverage to profit from the equities movement without holding the shares.

Options can be used to gauge sentiment, as the pricing (premium) of options is largely based on implied volatility on the asset you are trading. Implied volatility is the market’s forecast of future volatility which is based on the options price (Premium).

To see how much the stock actually moves in relation to the market, look at the stock’s beta. Every stock has a beta and can use this metric to gauge the historical volatility of a stock. A beta of 1 means the stock moves at the same pace as the market. Over 1 means the stock will move more than the market, and less than 1 indicates the stock moves less than the market when the market makes a move. For example, Tesla currently has a three-month beta of  2.10. So you can expect this stock to make large moves when the market moves.

Options are mainly based on statistics as is volatility which is the trader’s term for standard deviation. Why is volatility important if you aren’t trading stocks or options?

Because it gauges the anticipated movement of the market in the future, which is every investor or trader’s dream. Imagine if you knew the actual volatility that was expected to occur. With that knowledge, you’d have the advantage of knowing when to enter and exit positions just based on volatility.

You’d also have the ability to determine an option fair price and make trades based on this knowledge.

But back to the investment strategies that apply to today’s current economic environment, there are a number of ways you can adjust.

In the short term, there’s always a theme to the current market environment, a central concern or hope that participants are focusing on. Right now, market participants are focused on inflation and the Fed’s fight to tame inflation. From the short term, we can extrapolate possible environments and whether a bullish, bearish, or neutral strategy should be applied. It’s extremely challenging to predict what might happen in the next year, or the year after. A comforting thought you should keep in mind is professional money managers have a hard time beating the market year after year.

Investment Strategy: If you have the skill set, actively invest but watch the market closely as there are many variables that could cause the market to make large moves unexpectedly.

With inflation still relatively high and rates forecasted to remain higher for longer, it’s set to be a tough time for companies looking to maintain or increase their profit margins. Companies with a strong balance sheet should be the first set of companies you place on your list to review. Companies with strong management and a plan to navigate the rising cost of debt and the dwindling savings of consumers should be second on the list.

Investment Strategy: The market is attempting to call the Fed’s bluff on the continuation of rate hikes. If the market is wrong, that could increase the amount of volatility or uncertainty in the market. You can invest in short-term treasuries and wait for the uncertainty to subside. 

Recently, companies, especially in the tech industry, have begun to lay off employees to trim costs. Banks have begun to set aside funds to handle the defaults that they see arising as the economy slows and possibly enters into a recession. Banks have followed suit in laying off employees.

Investment Strategy: Buy and hold growth companies as they adjust their expenses to improve their bottom line. Look for companies having a rough time managing the higher rates, especially in the tech industry. Ideally, it would be companies that you know will be around for the next 10-15 years.

Uncertainty adds to the volatility in the market. We can use technical indicators like Bollinger bands and Average True Range to further gauge the stock’s recent movement. These indicators can alert an investor if the stock is overextended or due for an explosive move upwards.

Bollinger Bands:

Short term: 10-day moving average, bands at 1.5 standard deviations. (1.5 times the standard dev. +/- the SMA)

Medium-term: 20-day moving average, bands at 2 standard deviations.

Long-term: 50-day moving average, bands at 2.5 standard deviations.

(Definition from Fidelity)

Average True Range:

Average True Range (ATR) is the average of true ranges over the specified period. ATR measures volatility, taking into account any gaps in the price movement. Typically, the ATR calculation is based on 14 periods, which can be intraday, daily, weekly, or monthly. 

The True Range for today is the greatest of the following:

  • Today’s high minus today’s low
  • The absolute value of today’s high minus yesterday’s close
  • The absolute value of today’s low minus yesterday’s close

(Definition from Fidelity)

The one aspect of the economy that we can be certain of is that it is always changing. If we look at the energy sector, we can see a major change underway in the type of energy we use and produce, and the goals countries have set to shift from crude oil to renewable energy.

It’s important to understand that the longer rates remain higher, the risk of deglobalization rises, the China/US cold war tension intensifies, and the Russia/Ukraine conflict rages on, and markets will be on edge. If you take a look at the index’s charts, you can see the volatility market participants face.

Recently, volatility has edged below 20, signaling the market’s expectations that the movement of the market won’t be as extreme. If volatility remains low (Below 12 or between 12-20), we can expect that people might feel comfortable taking on more risks. If the market feels the times are set to return to some sense of normality, we can expect the markets to rise.

However, not every industry will partake in the market’s rise, as different industries have different variables that may be affecting the companies within the industries. I’d personally be looking for industries that have the potential to outperform once rates recede and the economy recovers from the eventual slowdown or recession.

One example would be the real estate sector which has particularly felt the effects of higher rates. Prospective home buyers have pulled back from purchasing a home due to high rates, although rates have fallen slightly these past few weeks. Another sector would be consumer discretionary, specifically durable goods which consumers have shunned as they switched to services.

Looking at the industry’s performance is a good way to find industries and stocks that are undervalued. Barcharts is an excellent resource to find potential trades and investments. Sometimes the best investments are found in the beaten-down sectors whose potential performance you can assess by looking at the business cycle and the current economic environment.

https://www.barchart.com/stocks/sectors/industry-heat-map

 Since we understand what volatility is and how it works, we can use it to our advantage to time entries and exits for long-term success.

One equation we can use is finding the volatility in terms of price movement the market anticipates.

Volatility/√x

Take the volatility and divide it by the square root of the time you’re interested in. For example, for weeks, we can take the volatility and divide it by 52 weeks to determine the price movement for the week. Once we have this number, we can use it to see how much the stock may move in the coming weeks.

This can allow you to devise a strategy for entering the stock you favor at an opportune time.

The most important thing investors must remember is that although volatility may be extreme at times while the market is falling, you have to stick to your investment plan. While I do check the markets daily for trading purposes, I try and leave my investments in place, especially if the company’s balance sheet is sound and management is focused on reaching their goals.

It can be tempting to exit the position once things look shaky but if you exit the investment based on the current market environment it can make it harder for you to reinvest. Perhaps the entry price might be higher or the capital you once had from exiting a position had to be used for something else.

Volatility is such a complex subject that papers have been written about it and how to trade it as an asset. It’s important to watch because volatility can shake weak hands or investors out of their positions.

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