Mastering Investment Tactics in Highly Volatile Markets: Strategies to Secure and Grow Your Wealth

Charlene Rhinehart is a CPA and CFE, leading an Illinois CPA Society committee, with a solid background in accounting and finance from DePaul University.

Investors are familiar with market cycles featuring bullish surges and downturns. However, navigating periods of extreme market volatility requires a strategic approach to prevent significant losses and protect prior gains.

Employing non-directional or probability-based trading techniques can help investors shield their portfolios from downturns while potentially profiting from heightened market fluctuations.

Essential Insights

• Volatility in financial markets indicates rapid and significant price movements.
• Increased volatility elevates the risk of partial or total investment loss.
• Directional investing depends on consistent market trends in a preferred direction.
• Non-directional investing capitalizes on market inefficiencies and pricing gaps.
• Volatile markets provide an opportunity to reevaluate and adjust investment strategies.

Understanding Volatility Versus Risk

Before selecting a trading approach, distinguish between volatility—the speed and extent of price changes—and risk, the chance of losing investment capital. All assets experience some volatility, with more volatile assets showing larger and more frequent price swings.

Risk encompasses potential losses from adverse market movements. As volatility rises, so does market risk, often leading to increased trading activity and shorter holding periods. Market reactions to news can become exaggerated during these times.

While higher volatility can lead to sharper downturns, it can also be managed through hedging strategies and, in some cases, leveraged for profit.

Protecting Your Portfolio Against Volatility

Long-term investors should prioritize hedging to mitigate downside risks during turbulent markets. Instead of selling shares or triggering stop-loss orders—which may incur taxes and reduce portfolio holdings—consider purchasing protective put options on individual stocks or broad indices like the S&P 500.

For example, if XYZ stock trades at $100 and you want to guard against losses exceeding 20%, buying an 80-strike put option allows you to sell at $80 regardless of further declines, effectively setting a safety net.

Important Consideration

If the stock price remains above the strike price until option expiration, the put will expire worthless, resulting in the loss of the premium paid.

Capitalizing on Volatility Through Trading

Investors interested in betting on volatility itself can trade ETFs or ETNs linked to volatility indices such as the CBOE Volatility Index (VIX), often dubbed the "fear index." These instruments typically increase in value when market volatility rises.

Options strategies like straddles and strangles—simultaneously buying calls and puts on the same asset—can profit from significant price swings in either direction.

Warning

VIX-based exchange-traded products are designed for short-term trading and are not suitable as long-term investments.

Exploring Non-Directional Investment Approaches

Unlike directional investing, which relies on markets trending consistently up or down, non-directional strategies exploit pricing inefficiencies and discrepancies without depending on market direction. This approach can perform well in both bullish and bearish conditions.

Equity-Market-Neutral Strategy

This strategy focuses on the relative performance between closely related stocks by going long undervalued shares and short overvalued peers within the same sector. Success hinges on precise stock selection, aiming to profit from the performance gap rather than overall market movements.

Tip

In volatile markets, implementing risk controls like stop losses becomes even more critical.

Merger Arbitrage

This tactic involves simultaneously buying the target company's stock and shorting the acquirer's stock during merger announcements, capitalizing on price discrepancies due to merger uncertainties.

Relative Value Arbitrage

This approach seeks correlated securities—typically heavyweight stocks within the same industry—that temporarily diverge in price, allowing investors to long the undervalued and short the overvalued security until prices converge.

Why Does Market Volatility Occur?

Market volatility spikes during periods of heightened fear or uncertainty, often triggered by economic downturns, geopolitical tensions, or unexpected disasters. Historical examples include the 2008-09 credit crisis and the 2022 Russia-Ukraine conflict.

Investment Vehicles Tracking the VIX Index

VIX futures trade on the CBOE and are accessible through select brokers. For broader access, ETFs and ETNs like the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX), iPath Series B S&P 500 VIX Mid-Term Futures ETN (VXZ), and ProShares VIX Short-Term Futures ETF (VIXY) provide exposure to volatility.

Understanding Probability-Based Investing

Probability-based investing leverages fundamental analysis to assess whether a stock’s market price accurately reflects its financial health and growth prospects. By comparing market expectations with actual company data, investors can gauge the likelihood that the stock will meet projected growth, identifying potential pricing inefficiencies.

Final Thoughts

In volatile markets, the key is to pause and reassess your investment objectives. Avoid panic selling or inaction, as both can undermine your goals. While volatility introduces greater risk, it also opens doors for strategic gains when approached thoughtfully.

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