Most investors are aware that the market undergoes times of strong trends and times of lateral ranging. 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, which 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.

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. There is a marked increase in the frequency of trades during these periods and a corresponding decrease in the amount of time that positions are held. During times of increased volatility, a hyper-sensitivity to news is often reflected in market prices.

Directional Investing
Most private investors practice directional investing, which simply requires the markets to move consistently in the desired direction, which can be either up or down. Market timers, long or short equity investors and trend investors 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 Investing
Non-directional investors attempt to take advantage of market inefficiencies and relative pricing discrepancies. Following are some 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. By 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 position can be quickly offset by a gain on a long one. 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 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 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? 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 5% or larger divergence 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.
  • Event Driven - This scenario is triggered by corporate upheaval, whether it be a merger, assets sale, restructuring or even bankruptcy. Any of these events can temporarily inflate or deflate a company's stock price 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.
Trading on Volatility
Investors who seek profits from market volatility can trade ETFs or ETNs on a volatility index such as iPath S&P 500 VIX Short-Term Futures ETN (ARCA:VXX). The VXX tracks the movement of the CBOE volatiliy index (VIX). During the budget impasse and debt ceiling problem in 2013, VXX rose nearly 21%. After the problem was solved, it fell nearly 30%. If investors had bought VXX before it rose significantly and sold at the peak, they would have realized large profits.

Probability-Based Investing
Although investors' consensus opinion will usually result in a relatively efficient stock price that reflects all known information, there are obviously times when one or more key pieces of data about a company are not widely disseminated, resulting in an inefficient stock price that is not reflected in its beta. The investor is therefore taking an additional risk of which he or she is most likely unaware. Probability-based investing is one strategy that can be used to help determine whether this factor applies to a given stock or security. Investors who employ this strategy will compare the company's future growth as anticipated by the market with the company’s actual financial data, including current cash flow and historical growth. This comparison allows calculating the probability that the stock price is truly reflecting all pertinent data. Companies that stand up to the criteria of this analysis are therefore considered more likely to achieve the future growth level that the market perceives them to possess.

The Bottom Line
Volatile times provide an opportunity to reconsider one's investment strategy. Although the approaches described here are not for all investors, they can be leveraged by the experienced trader and alternatively, each option is available through a professional money manager.

Related Articles
  1. Markets

    Using Historical Volatility To Gauge Future Risk

    Use these calculations to uncover the risk involved in your investments.
  2. Options & Futures

    Market Volatility Strategy: Collars

    Find out which protective or bullish collar will result in your optimal risk/return level.
  3. Active Trading Fundamentals

    Tracking Volatility: How The VIX Is Calculated

    When market volatility spikes or stalls, newspapers, websites, bloggers and television commentators all refer to the VIX®. Formally known as the CBOE Volatility Index, the VIX is a benchmark ...
  4. Options & Futures

    Determining Market Direction With VIX

    The CBOE's volatility index is a helpful market indicator. Learn how it can gauge the mood of the stock market.
  5. Mutual Funds & ETFs

    The VIX: Using The "Uncertainty Index" For Profit And Hedging

    Learn the best ways to profit and hedge using the Chicago Board Options Exchange Market Volatility Index.
  6. Mutual Funds & ETFs

    Mutual Funds Are Not FDIC Insured: Here Is Why

    Find out why mutual funds are not insured by the FDIC, including why the FDIC was created and how to minimize your risk with educated mutual fund investments.
  7. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  8. Professionals

    Fund and ETF Strategies for Volatile Markets

    Looking for short-term fixes in reaction to market volatility? Here are a few strategies — and their downsides.
  9. Investing Basics

    Tops Tips for Trading ETFs

    A look at two different trading strategies for ETFs - one for investors and the other for active traders.
  10. Investing

    How Diversifying Can Help You Manage Market Mayhem

    The recent market volatility, while not unexpected, has certainly been hard for any investor to digest.
  1. What is the CBOE Volatility Index? (VIX)

    The Chicago Board Options Exchange (CBOE) calculates a real-time index to show the expected level of price fluctuation in ... Read Full Answer >>
  2. Can your car insurance company check your driving record?

    While your auto insurance company cannot pull your full motor vehicle report, or MVR, it does pull a record summary that ... Read Full Answer >>
  3. Are mutual funds considered retirement accounts?

    Unlike a 401(k) or Individual Retirement Account (IRA), mutual funds are not classified as retirement accounts. Employers ... Read Full Answer >>
  4. Do penny stocks pay dividends?

    Because of the small market capitalization and revenues typical of most penny stocks, there are very few that offer dividends. ... Read Full Answer >>
  5. Can you buy penny stocks in an IRA?

    It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>
  6. Where do penny stocks trade?

    Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!