VIX is a ticker published by CBOE that tracks near-term volatility. Since it tracks S&P 500 options, it is representative of market volatility in general. Since August 1, 2015, VIX has crossed the value of 30 five times and has been to the higher 20s more than 20 times. That means the market has been fairly volatile. Any value above 30 indicates widespread uncertainty and fear. In this article we will explore ideas on how investors can profit from a volatile market.
What Happens When Markets Are Volatile?
In our real lives, we tend to run helter skelter when there is a situation that is affecting everyone’s safety. The same thing happens in the stock market. Fear and uncertainty forces investors to make knee-jerk decisions. There is little or no agreement as to what might happen in the future and that difference in opinion causes stock prices to change directions sharply every other day.
If you have a portfolio that you need to protect, this can be a very stressful time. You might feel like selling your high-beta positions. If you have good dividend-paying ETFs, you want to protect them. You might even find yourself jumping in and out of the market losing not only capital value but also commissions. If you decide to ride it out without making any changes, you could end up watching your portfolio go down in value.
How to Maximize a Short Window of Opportunity
In times of uncertainty there are often short windows of opportunity investors can exploit. When you spot that opportunity, you want to make full use of it without disturbing your long-term portfolio. You can only do that if you react quickly. The idea is to increase your risk-reward equation without compromising principles of diversification. Here are some ideas that might help:
- Index options: Index options offer the advantages of diversification and leverage while limiting the downside to losing only the premium paid (options give you the right to buy/sell but no obligation). If, however, you are shorting (or writing or selling to open) option contracts, your potential downside is much larger. Naked call positions expose investors to theoretically unlimited losses. It’s also important to remember that you are not buying any assets. If the option expires then the premium is gone. In case of assets, you still have a residual value if its value declines (e.g. a stock or a debt instrument).
- Index Futures: This strategy provides the advantages of diversification and leverage. It does, however, expose investors to substantial risk.
- Multi-Leg Option Strategies: Multi-leg option strategies can allow investors to cut the downside risk and yet take reasonably leveraged positions. For example, if you are bearish you could consider a bear put spread in which you buy in the money puts at a higher strike price and sell out of money puts at a lower strike price. Just remember that with this strategy both losses and profits are limited.
- Leveraged ETFs: Leveraged ETFs offer the advantages of diversification, leverage, and some net new advantages (as compared to derivatives) such as lower tax, lower cost and higher convenience.
A Case for Leveraged ETFs
Anything to do with derivatives is a good option for those who have the time and experience to execute complex trades. Even with the appropriate knowledge investors need to pay a lot of close attention (which takes time) to execute good strategies. A margin account is also needed to enter the trades (and these charge interest every time you use leverage).
Leveraged ETFs, on the other hand, are much simpler to buy and sell. When you have to react quickly, convenience becomes a key factor. Even if the ETFs execute derivative contracts under the hood, those complexities are not exposed to the investor; it is a simple buy and sell. Additionally, it is much simpler to buy an inverse ETF than short a stock. You can hold the position as long as you want without worrying about giving back the borrowed stock.
Let’s take an example of how a short window of opportunity can provide very lucrative returns using leveraged ETFs. In the past week, there has been some discussion about oil production cuts. Production cuts will reduce the oil supply and help increase oil prices. Even though it is speculative at this stage, the news has had a positive impact on the market (which is not too hard to predict). (UWTI ), a 3x long oil ETF, has gone up by nearly 40% from October 2 to October 8.
The Bottom Line
Whether or not to use leverage as part of your strategy boils down to your risk appetite. At times it makes sense to use leverage in order to utilize a short window of opportunity rather than changing the portfolio you’ve built with a long-term vision in mind. Leveraged ETFs are very quick and convenient to trade. And by investing in an ETF, you are getting the advantage of diversification as well.
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