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.
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 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.
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.