The latest spell of higher stock market volatility is on the mind of many professional and retail investors. Up until this latest outburst, volatility as measured by the S&P 500 Volatility Index or “VIX” had crashed 36%.
While stock market volatility is often portrayed as an evil force that people should strive to avoid, it can and should be used to an investor’s advantage.
Let’s consider three lessons for successfully dealing with and even capitalizing on higher volatility.
Lesson 1: Volatility Isn’t Necessarily a Foe
One way to benefit from higher stock market volatility is to invest alongside of it. Although it’s impossible to invest directly in volatility gauges like the VIX, there are plenty of choices like VIX call options and ETPs. Let’s look at an example.
In the ETFguide Profit Strategy Newsletter*, a recommendation was given to go long the ProShares ST Futures VIX ETF (VIXY) on April 9 at $15.95.
Unfortunately, this trade on stock market volatility turned out to be dead money over the next few months because volatility sank like a rock. At one point, the VIXY position recommended had unrealized losses of 35%, ouch!
However, the recent 100% plus surge in stock market volatility caused VIXY’s share price to skyrocket and per the newsletter, a trade alert was given to sell VIXY at $19.63 on September 1 for a 23% gain. What’s the lesson?
First, investing in volatility isn’t for the faint of heart and second, good trades can sometimes start out poorly. However, in the proper context of a complimentary role to a much larger fully diversified core portfolio, embracing volatility rather than avoiding it certainly has a place.
Lesson 2: Volatility Leads to Discrepancies
Elevated volatility often leads to a bevy of stock market discrepancies and whenever there are discrepancies there’s opportunity. However, these aberrations don’t last forever. For advisors to take advantage of them, it’s important to maintain cash in client portfolios. Why?
Cash – as opposed to the 100% full invested portfolio – gives advisors greater flexibility during extreme markets. Not only does it cushion a client’s portfolio against falling prices, but cash gives advisors the luxury of buying assets that go on sale.
In contrast, fully invested portfolios are unable to pounce on these temporary moments of high volatility and stock market fear.
Lesson 3: Volatility Reveals Problems
The problem with bull markets is that they camouflage the weaknesses of a person’s investments. But whenever the stock market is volatile, we inevitably find out who’s been swimming naked. We find out which group of investors has been over-leveraged, over-concentrated in the wrong securities, or otherwise taking too much risk.
Volatile markets will also reveal which investment portfolios are poorly constructed versus those that are architecturally sound. From a financial advisor’s perspective, volatile markets are an outstanding opportunity to help clients to identify and eliminate weaknesses. Use higher volatility as an opportunity to improve the design of client portfolios.
In summary, use rising stock market volatility to your client’s advantage. Soar like an eagle when the rest of the world is crashing.
*Ron DeLegge is the founder of ETFguide.