The world has always been an uncertain place. That is the reason for the fundamental risk-reward balance in finance. The contemporary world offers unprecedented access to information to unprecedented numbers of people across the globe. Anyone with an Internet connection can track how the market is performing. This flood of information and participants is a double-edged sword: on one hand, there is sufficient volume for daily trading, but on the other hand, herd mentality is even more influential and contrarian views may be useless, even if they are based on rational calculation.
News events first published on Twitter can spiral into market-gutting trends with little evidence except for a few people on the ground. In long-term situations that cause volatility, like Brexit, this is mitigated, but in rapidly-shifting situations, like the development of social upheaval or catastrophic wars, it may not matter what the truth is – only what the market perceives the truth to be. With leaders like Trump and Kim Jeong-Un wielding massive militaries and possibly larger egos – not to mention the problems emergent from Brexit, Venezuela, Middle Eastern turmoil and reactive movements against globalization – the average investor must remain vigilant and understand their own risk tolerance and portfolios.
Below are some points to consider when building or maintaining a portfolio for these volatile and information-rich times.
You can track personalised financial news for VIX and ETFs on our award-winning platform CityFALCON here.
First and foremost is being aware of what is happening. You don’t have to drown in a torrent of data, but don’t check the news once a month, either. Staying abreast of the current situation is relatively easy today. Subscribe to Twitter and RSS feeds to have a constant but manageable stream of relevant news. Automate as much of the process as possible, so set targeted alerts rather than broad ones. If you are overwhelmed with reading material, you won’t be able to make informed decisions. You’ll miss vital information while sifting through less relevant information.
CityFALCON can help with this, as one of our foundational goals is to provide relevant information to investors. If you don’t want to curate and track all the important information on your own, we can fulfill that investing need. Whether using our services, another company’s, or your own curation methods, make sure you are aware of the current situation.
Hedging for Protection
One of the most secure ways to protect your investments in volatile times is to hedge. If you build a perfect hedge, the market’s movement is inconsequential. Your portfolio will retain its current value. That is also the drawback of hedging: risks are mitigated but so are gains. However, sometimes you don’t want to waste money buying and selling portfolios or missing ex-dividend dates. For this, you can hedge.
Options provide a convenient, sufficient-volume instrument to “insure” your portfolio. The premium paid for the option, if the option is purchased solely for hedging, is similar to an insurance premium. There are plenty of resources online to help you implement complex or simple hedging strategies with options for all sorts of markets. For volatile markets, you want to avoid large price swings; if you are hedged, you can rest assured whipsawing prices won’t impact your portfolio.
Options can also provide a means of income, and a very large one at that. However, misusing options can lead to excessive losses (more than your investment), so be careful. Simply buying call or put options carries little risk. Writing options carries more risk, and naked writing (often disallowed by brokers) carries significant, potentially unlimited, risk, so only write options if you are a sophisticated investor. For the sole purpose of hedging, options are a cash outflow, not inflow.
ETFs as a Hedge
Hedging with ETFs requires the investor to be well-aware of his/her own portfolio. Options let you build a perfect mirror of your portfolio (assuming there are standardized options for your assets), while ETFs are a bit less exact. ETFs publish their underlying assets, so if you have a similarly weighted portfolio, ETFs are a good choice, because you won’t have to buy and sell several assets to maintain balance – just a couple ETFs that reflect your holdings. This is also less complex than building hedging strategies with options, so the average, less sophisticated investor can still reap the benefits of a protected portfolio.
Making Money from Volatility
Above we outlined how to avoid losing money in a volatile market. But employing hedges severely limits your upside, too. In order to profit from volatility, there are ETFs available. The volatility index (VIX) is a measure of the rate of price movements, and if you expect volatility to rise, you can go long on this index.
Looking at the chart, there are notable spikes in 1998 through 2002, and of course, September and October 2008 are very prominent on the right. There are also significant increases in May/June 2010 (bailout of Greece during debt crisis) and August to October 2011 (US credit rating downgrade and debt ceiling fight). The chart to the right of 2011 is comparatively calm, with an exception in August 2015.
Volatility skyrockets upon global developments, so it is essential to stay aware of the news. Furthermore, buying before major announcements can be profitable, as markets tend to panic more after negative news than remaining calm after the expected news.
ETFs to diversify and reduce risk
If it seems certain sectors will be explosive, consider ETFs on those sectors. They are a good way to easily diversify and gain broad exposure, and highly liquid ones are easy to snap up or dump, depending on market conditions. If you don’t already own a broad portfolio, ETFs can help you gain exposure without risking too much in a single company or incurring prohibitive transactions costs.
Quality stocks in your portfolio
Buying stable equity in stable markets affords one the ability to stay invested but away from most of the turmoil. However, you must perform your due diligence. The world is interconnected like never before, and large companies often have very long supply chains. These tend to weave in and out of various nations, and even if the product is stamped with “Made in ___”, it is highly likely components have passed through several countries before assembly.
Consider non-equity asset classes
If markets are too volatile but you don’t want to stay out of the market, fixed income is also a
solid strategy. FI will offer a lower return (assuming you invest in stable bonds), but you can expect some appreciation, as opposed to the continual devaluation of cash due to inflation. If you decide to use FI, know how pricing mechanisms work. With the low-interest rates that have been prevalent for so long, you must seriously consider interest rate hikes. Bond prices move inversely to interest rates, so if you start into FI, you might be invested in them for a while to avoid losses.
As an example, if you buy Bond A at $95 ($100 face) and with a 2% coupon, but the interest rate rises next month and the price of the bond falls to $93, you already lost $2 per bond. You would have to wait to recover coupon payments or for price appreciation before selling, otherwise you immediately incur a loss. On the other hand, if interest rates remain flat, you can collect on the coupon. FI ensures the growth of wealth while remaining largely isolated from the volatile equity markets, though problems in equity can spill over into the bond market, especially if a major event occurs.
Timing the Market
Avoid timing the market. It will likely result in losses or significantly reduced gains. If you have a well-reasoned approach, including aspects of market psychology, you should be confident in your strategy. If fundamentals have shifted, you can exit, but do not exit on emotion or too hastily.
If you’re a long-term investor, then it might actually be best to simply remain invested in volatile times. According to Fidelity Investments, if you missed just the 5 best days since Jan 1, 1980 (until May 31, 2017), you would have lost out on more than $200,000 profit from a $10,000 investment. Since it is impossible to predict when a bear market might suddenly become a bull market, missing these days is easy. Worse yet, you could lose significantly more if you sold at the bottom, bought again at the top in an attempt to capture gains, and sold again at the bottom to cut losses. Long term trends might be more accurate, but 5 days out of 37 years becomes noise. It is extremely difficult to predict when to enter and exit, and impossible to hit highs and lows often enough to make timing the market worthwhile.
Cash is King (sometimes)
In highly volatile times, when war or social upheaval crosses the point of ignition, leaving the market is not a bad idea. It is much easier if you are broadly exposed via ETFs. In the unlikely scenario that social order will break down in your target country, it is imperative to move your assets out of equity and not hedge with options. While hedging strategies look good on paper, they’re only as solid as the foundation of the market upon which they rest. If entire country experiences extreme disruption, both your equity and your options embedded in the host nation’s financial system could become worthless.
Forex markets will also mirror current events. If you hold the currency of an at-risk nation, you should consider hedging against the currency itself. Hedging (with assets based in stable countries) can provide some security. Once the turmoil starts, it is too late to exit the market, anyway.
Dangers to Consider
There are a few oft-overlooked dangers in trading during turbulent times. They are not obvious and you may not consider them until you face them directly. They are more important for short-term traders, but long-term investors need to be aware of them, too, because long-term investment still requires decisions and implementations to be made at some point in time.
If you trade on an online platform, website downtime and system failure are real possibilities during heavy trading periods. If you’ve ever accessed a high-traffic website during a major event, you know it can be sluggish or simply unresponsive. This might limit your ability to trade and is one excellent reason to prepare before an outbreak.
In extremely high-volume times, there might be a significant delay between the quoted price and the possible execution prices in the market. This is most apparent during a “flash crash”, but the sudden outbreak of turmoil could also cause a selling frenzy – especially if the market expects the outbreak to become systemic.
And while in normal times it is advisable to use stop and limit orders, extreme market conditions may trigger stops too frequently, resulting in heavy losses and missed gains. This danger can be avoided by having a long-term defense against market volatility or the will to weather rapid market shifts. The latter is not a quality most people possess, so you may want to consider hedging as a continual aspect of your trading strategy.
What effects will come of Brexit, North Korea, Venezuela, or other tense situations no one can predict. Protect yourself from wild markets, stay aware, and, if you feel the situation is too tense, consider leaving the market for a while. Do not make decisions based on fear or panic. The best way to avoid panic is to implement a well-reasoned and calculated approach before turmoil – once the chaos begins, it is too late to start defending your positions. If you’re prepared, you will feel much less pressure to act immediately to mitigate losses.
You can track personalised financial news for VIX and ETFs on our award-winning platform CityFALCON here.