Is it possible to gauge the level of anxiety in the investment markets? Certainly, and The Chicago Board of Exchange Volatility Index (VIX) measures it. The VIX reacts in real time - just as a stock does - and measures the level of volatility in the U.S. markets over the next 30 days. When the VIX is at 30, in the next 30 days the market could move as much as 2.5% in either direction, (30% divided by 12 months equals 2.5%). The VIX has hovered around 30 for the latter part of 2011, indicating that the market is still highly volatile.

Although short-term traders may call periods of high volatility great times to make money, the truth is that traders of all skill levels will face challenges in this market. What can you do to protect your portfolio against the wild stock market swings? Though it may not sound exciting to the average active trader, the best defense is to stick with conservative, "boring" strategies.

TUTORIAL: Risk and Diversification

Hedge
Think of hedging as an insurance policy. Let's assume that you own Bank of America stock and it is now in a market decline. One way to hedge would be to purchase a put option, with a strike price below where you purchased the stock. You won't lose money on any move below your strike price. Other hedging options include short selling a stock and purchasing put options on index funds, like popular exchange traded fund SPDR S&P 500 (NYSEArca:SPY). (To learn more on hedging, read Hedging Basics: What Is A Hedge?)

Low Beta
Beta is the measure of volatility in a particular security. If a stock has a beta of one, expect it to move at the same rate as the S&P 500. A stock with a beta below 1.0 is less volatile than the market index; a beta that is higher is more volatile. In times of extreme market volatility, concentrate on low beta stocks that pay a dividend. (For more on this volatility measure, read Beta: Know The Risk.)

Stay Out
At the end of 2011, the market saw trading volume substantially drop. Some market insiders attributed this to professional investors who were tired of the whipsaw action of the stock market, so they took some of their money out of the market, determined to wait until the VIX went down.

Retail investors who are trading in the market have to know when the market is too volatile and exit into safe haven investments. Investors who have long-term portfolios should not do anything. The market will stabilize, but until then, rely on dividends for safe, consistent income.

Stick with the Index
Efficient market hypothesis (EMH) is a theory that states that it's impossible to beat the overall market. This means that individual stock picking will not yield better results over the long term, so investing in an index fund is the statistical best way to make money, especially in times of extreme volatility. Don't expect stocks to act rationally; consider staying with the index. (To learn more on the history of indexes, check out .)

Increase Your Time Horizon
Times like these make trading a losing game for many. Until the markets calm down, consider increasing your time horizon. Find an undervalued stock or buy an index fund when the market is at the bottom of its range. Commit to holding the position for at least a year, unless something drastic happens. The longer you invest, the easier it is to make money. Remember, every dividend payment decreases the cost basis of your stock.

The Bottom Line
Professional investors know that often the best action is the lack of action. Don't respond to the markets; position yourself with a long-term portfolio that can set you up for any type of market.

Related Articles
  1. Fundamental Analysis

    Examining Mexico's Trillion-Dollar GDP

    Examining the gross domestic product growth and composition of Mexico, the second largest economy in Latin America
  2. Investing

    Redefining the Stop-Loss

    Using Stop-losses for trading doesn’t mean ‘losing money’, but instead think about the money you'll start saving once you learn how they work.
  3. Mutual Funds & ETFs

    ETF Analysis: First Trust Dow Jones Global Sel Div

    Find out about the First Trust Dow Jones Global Select Dividend Index Fund, and learn detailed information about characteristics and suitability of the fund.
  4. Mutual Funds & ETFs

    ETF Analysis: U.S 12 Month Natural Gas

    Learn about the United States 12 Month Natural Gas Fund, an exchange-traded fund that invests in 12-month futures contracts for natural gas.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares Floating Rate Bond

    Explore detailed analysis and information of the iShares Floating Rate Bond ETF, and learn how to use this ETF as a defense against rising interest rates.
  6. Mutual Funds & ETFs

    ETF Analysis: ProShares UltraPro Short S&P500

    Find out information about the ProShares UltraPro Short S&P 500 exchange-traded fund, and learn detailed analysis of its characteristics and suitability.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares US Healthcare

    Learn about the iShares U.S. Healthcare exchange-traded fund, which invests in a wide range of health care providers, hospitals and home care facilities.
  8. Mutual Funds & ETFs

    Top 5 Japan Mutual Funds

    Discover five of the most popular and best-performing mutual funds offering investors direct exposure to equities of Japanese companies.
  9. Fundamental Analysis

    What Causes Inflation in the United States

    Inflation is the main catalyst behind U.S monetary policy. But what causes this phenomenon of sustained rising prices? Read on to find out.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares US Basic Materials

    Learn about the iShares US Basic Materials exchange-traded fund, which invests in the equities of chemicals, metals and industrial gas companies.
RELATED TERMS
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Normal Profit

    An economic condition occurring when the difference between a ...
  4. Cost Accounting

    A type of accounting process that aims to capture a company's ...
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s ...
  6. Theta

    A measure of the rate of decline in the value of an option due ...
RELATED FAQS
  1. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  2. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  3. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  4. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  5. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  6. What percentage of a diversified portfolio should large cap stocks comprise?

    The percentage of a diversified investment portfolio that should consist of large-cap stocks depends on an individual investor's ... 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!