Volatility From the Investor's Point of View

Stock market volatility is arguably one of the most misunderstood concepts in investing. Simply put, volatility is the range of price change a security experiences over a given period of time. If the price stays relatively stable, the security has low volatility. A highly volatile security hits new highs and lows quickly, moves erratically, and has rapid increases and dramatic falls.

Because people tend to experience the pain of loss more acutely than the joy of gain, a volatile stock that moves up as often as it does down may still seem like an unnecessarily risky proposition. However, what seasoned traders know that the average person may not is that market volatility actually provides numerous money-making opportunities for the patient investor.

Investing is inherently about risk, but risk works both ways. Each trade carries with it the risk both of failure and of success. Without volatility, there is a lower risk of either.

Volatility and Market Fluctuation

Volatility can benefit investors of any stripe. Many more conservative traders favor a long-term strategy called buy-and-hold, wherein a stock is purchased and then held for an extended period, often many years, to reap the rewards of the company's incremental growth. This strategy is based on the assumption that while there may be fluctuations in the market, it generally produces returns in the long run. 

While a highly volatile stock may be a more anxiety-producing choice for this kind of strategy, a small amount of volatility can actually mean greater profits. As the price fluctuates, it provides the opportunity for investors to buy stock in a solid company when the price is very low, and then wait for cumulative growth down the road.

Swing and Short-Term Traders

For short-term traders, volatility is even more crucial. Day traders work with changes that occur second-to-second, minute-to-minute. If there is no price change, there is no profit. Swing traders work with a slightly longer time frame, usually days or weeks, but market volatility is still the cornerstone of their strategy. As price seesaws back and forth, short-term traders can use chart patterns and other technical indicators to help time the highs and lows.

Using indicators such as Bollinger Bands, a relative strength index, volume, and established support and resistance levels, swing traders can pick out potential reversal points as price oscillates. This means they can go long on the stock, or buy calls, as the price nears a low and then ride the upswing to sell at or near the high.

Similarly, predicting when a volatile stock is exhausting its current bullish momentum can mean shorting the stock, or buying puts, just as the downturn begins. These types of short-term trades may produce smaller profits individually, but a highly volatile stock can provide almost infinite opportunities to trade the swing. Numerous lesser payoffs in a short period of time may well end up being more lucrative than one large cash-out after several years of waiting.

Trading the VIX

The Cboe Volatility Index, or the VIX, is a real-time market index that represents the market's expectation of 30-day forward-looking volatility.

Derived from the price inputs of the S&P 500 Index options, it provides a measure of market risk and investors' sentiments. It is also known by other names like "Fear Gauge" or "Fear Index." Investors, research analysts, and portfolio managers look to VIX values as a way to measure market risk, fear, and stress before they make investment decisions.

Volatility-based securities that track the VIX index were introduced in the 2010s, and have proved enormously popular with the trading community, for both hedging and directional plays. In turn, the buying and selling of these instruments have had a significant impact on the functioning of the original index, which has been transformed from a lagging into a leading indicator.

VIX futures offer the purest exposure to the indicator’s ups and downs but equity derivatives have gained a strong following with the retail trading crowd in recent years. These exchange-traded products (ETPs) utilize complex calculations layering multiple months of VIX futures into short and mid-term expectations. Major volatility funds include:

• The S&P 500 VIX Short-Term Futures ETN (VXX)
• The S&P 500 VIX Mid-Term Futures ETN (VXZ)
• The VIX Short-Term Futures ETF (VIXY)
• The VIX Mid-Term Futures ETF (VIXM)

Trading these securities for short-term profits can be a frustrating experience because they contain a structural bias that forces a constant reset to decaying futures premiums. This contango can wipe out profits in volatile markets, causing the security to sharply underperform the underlying indicator.

As a result, these instruments are best utilized in longer-term strategies as a hedging tool, or in combination with protective options plays.

Volatility and Options Trading

In times of high volatility, options are an incredibly valuable addition to any portfolio. Puts are options that give the holder the right to sell the underlying asset at a pre-determined price. If an investor is buying a put option to speculate on a move lower in the underlying asset, the investor is bearish and wants prices to fall.

On the other hand, the protective put is used to hedge an existing stock or a portfolio. When establishing a protective put, the investor wants prices to move higher but is buying puts as a form of insurance should stocks fall instead. If the market falls, the puts increase in value and offset losses from the portfolio.

While puts gain value in a down market, all options, generally speaking, gain value when volatility increases. A long straddle combines both a call and a put option on the same underlying at the same strike price. The long straddle option strategy is a bet that the underlying asset will move significantly in price, either higher or lower.

The profit profile is the same no matter which way the asset moves. Typically, the trader thinks the underlying asset will move from a low volatility state to a high volatility state based on the imminent release of new information. In addition to straddles and puts, there are several other options-based strategies that can profit from increases in volatility.