Don’t Fear Market Volatility, Prepare for It

There are several ways to consider market risk, but for many traders it comes down to their ability to tolerate volatility – or the upward and downward gyrations of the market. To be honest, many may not worry about big upward spikes. It’s the roller coaster-like freefalls that can have investors wanting to get out at exactly the wrong time.

“I think most people intuitively understand that markets don’t move up in a straight line,” said Brian Bachelier, vice president of active trader strategy at Scottrade. “At the same time, many investors and traders aren’t prepared when the market falls. They can end up selling at the wrong time, when the market is at a bottom.”

The Fear Index

Volatility can’t be easily predicted. But some traders focus on the Chicago Board Options Exchange’s volatility index, or VIX. Popularly called the Fear Index, the VIX effectively measures market sentiment for the next 30 days through the movement of option prices of SPX, which represents the S&P 500.

It’s important to know, however, that the VIX isn’t foolproof. No one really knows what the market might do in the future. The VIX measures expected short-term (30 days) volatility. It can be seen more as a sentiment gauge than a predictive one. However, understanding that sentiment can be useful to traders by potentially answering this question: Does the market expect a trend to reverse?

Depending on how you act on that sentiment, you might be able to hold positions that can either help protect you from or allow you to potentially capitalize on volatility. Of course, if you’re wrong, your losses could be magnified. Rather than protecting or profiting, you could end up expanding your losses.

Volatility Trading

Some highly experienced traders might turn to exchange-traded funds that track the daily movement of the VIX. But the ETFs themselves can be  highly volatile. Some are designed to rise as expected volatility increases, and others will do the opposite.

In either case, volatility ETFs are speculative products and should be used only with the understanding that big losses can occur.

A Portfolio and Diversification Approach

Unless you put the vast majority of your savings in cash, it’s impossible to eliminate all downward volatility. But investors can help potentially smooth out the hills and valleys by holding a diversified portfolio of uncorrelated assets.

Uncorrelated simply means holding investments that don’t move in the same direction or at the same magnitude at the same time. For example, stocks and bonds are not well correlated. More subtly, the price of stocks in one sector might diverge from stocks in other sectors. International stocks and domestic stocks (or international bonds vs. domestic bonds) aren’t always moving in lockstep either.

“In general, the less diversified your portfolio, the greater the risk that you’ll take a direct hit when the market plummets,” Bachelier said. “At the same time, if you understand what volatility means, you can take steps designed to protect yourself or even potentially benefit.”

Question: How much volatility can you accept in your trading or in your portfolio?

Read more: 6 Tactics to Help Protect Your Trading Plans

The analytical tools, examples and strategies described are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or endorsement of any specific investment, tool or strategy. The choice to use a specific investment tool or strategy should be based solely on your research and evaluation of risks involved, your financial circumstances, and your investment objectives.

An investment cannot be made directly in an index.

Diversification does not assure a profit, or protect against loss, in a down market.

Investors should consider the investment objectives, charges, expense, and unique risk profile of an Exchange Traded Fund (ETF) before investing. A prospectus contains this and other information about the fund and may be ordered through www.scottrade.com or through a Scottrade branch office.  The prospectus should be read carefully before investing.

Investing in international securities can involve substantial risks and is not suitable for all investors. These risks include, but are not limited to currency risk, political risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.

Bonds involve risks including, but not limited to interest rate risk, reinvestment risk, inflation risk, call risk, liquidity risk, credit risk, market risk, default risk, event risk, and a risk of loss of principal. New issue offerings are sold by prospectus or offering circular available at www.scottrade.com. Investors should read these carefully.

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