Most investors are aware that the market undergoes times of strong trends and times of lateral ranging. As a result, many investors employ a different trading system for each environment. But what happens in a period of extreme volatility? Any system a trader might use is susceptible to the increased market swings, and this vulnerability could wipe out previous gains and more. By using either a non-directional or a probability-based trading method, investors may be able to more fully protect their assets. Read on to find out how.
When Volatility Increases
It is important to understand the difference between volatility and risk. Volatility in the financial markets is seen as extreme and rapid price swings. Risk is the possibility of losing some or all of an investment. So as volatility increases, so does profit potential and the risk of loss, as the market swings from peaks to troughs. Frequent traders notice a marked increased in the frequency of trades and the decreased time the position is held. During times of increased volatility, a hyper-sensitivity to news is often reflected in market prices.
Why are times of extreme volatility potentially devastating to private investors? Quite simply, most private investors practice directional investing. Market timers, long or short equity investors, and trend investors all rely on directional investing strategies. The 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 investors attempt to take advantage of market inefficiencies and relative pricing discrepancies. The following are some of the strategies they deploy.
- Equity Market Neutral - 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. Focusing on the sector and not the market as a whole, emphasis is placed on movement within a category. Consequently, a loss on a short stock can be quickly offset by a gain on a long. The trick is to identify the standout and the underperforming stocks. The principle behind this 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 therefore will be less susceptible to market volatility.
- Merger Arbitrage - Many private investors have noticed that the stock 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 often 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 should simultaneously buy the target company stock and short 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? 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 5% or larger divergence lasting for two days or more is a sign that you can open a position in both securities with the expectation they will eventually converge.
- Event Driven - This scenario is triggered by corporate upheaval, whether it be a merger, sale of assets, some sort of restructuring or even bankruptcy. Any of these events can temporarily inflate or deflate a company's stock prices while the market attempts to judge and value these newest developments. This strategy does require analytical skills to identify the core issue and what will resolve it as well as the ability to determine individual performance relative to the market in general.
- Fixed Income - Where the bond is king. Fixed income investing yields a regular (fixed) return. A bond is issued by national governments, local governments or major corporations. Although fixed income has been a traditional safe haven, investors should be aware that the correlation between fixed income and the equities markets has increased.
Probability-based strategies may appeal to the advanced investor. They feature non-linear investment patterns, designed to profit under various market conditions. Designed correctly, these strategies can yield profit on either side of the entry points. The probability-based approach, while complex, can facilitate advanced risk management.(by Ian Huntsley)