Here’s How To Make The Most Out Of Volatility – An eBook Review
Rapid changes in the price of a financial security can unnerve even the most experienced investor. Those who have invested for the long-term can be tempted to sell their holdings when the market falls steeply.
Even so, a sharp increase in stock valuations can also be disturbing. This uncertainty result in the question of – time.
Is the rise just a temporary phenomenon or is it the beginning of a new upward trend that will continue for months or years? Will it be a good time to buy or should you wait till there is greater clarity about the direction that the market is taking?
In 2017, investors did not really need to answer these questions. The bull market had entered its ninth year and share valuations were consistently rising.
In fact, in 2017, the S&P 500 index exhibited an absolute daily percentage change of only 0.3% – the lowest since 1964. The market climbed steadily upwards and delivered positive returns on a consistent basis.
But that changed in February 2018, just into the second month of the New Year and financial markets have already been rising and falling at a rapid pace. The Chicago Board Options Exchange’s (Cboe) Volatility Index, which is also referred to as the “fear index,” registered a change of 115.6% on 5 February, its highest ever in a single day.
But do rapid changes in valuations always put investors at a disadvantage? Is there any way to trade in such volatile markets?
We decided to understand market volatility better as we dive into the latest eBook written by IG Markets, Make The Most Of Volatility. This eBook tells you how volatile markets can provide trading opportunities for traders, giving information that can be used to devise an investment strategy which can work amidst volatile market situation.
In addition to this, Make The Most Of Volatility addresses important issues for different asset classes.
However, before talking about the specific steps that you can take to gain from volatility, it’s important to familiarise yourself with the VIX.
Understanding how the Volatility Index works
Cboe Global Markets, one of the world’s largest exchange holding companies, created the Volatility Index (VIX) in 1993. The VIX essentially measures the market’s expectation of future volatility.
It is based on options of the S&P 500 Index. The calculation methodology involves aggregating the weighted prices of S&P 500 Index puts and calls over a wide range of strike prices. In simpler terms, the VIX tracks the prices that investors are willing to pay for options.
When expectation that volatility is going to rise, investors are willing to pay a greater amount. You should bear in mind that the VIX tracks prices on the Options market, NOT the stock market itself.
Profiting from volatility
How can investors take advantage when stock market valuations show large increases followed by steep declines? Make The Most Of Volatility points out, “Stocks fall faster than they rise, but they rise more often than they fall.”
The VIX provides a way in which you can trade from the gyrations of the market. It is possible to trade CBOE VIX Futures and VIX Options contracts. These derivative contracts allow investors an effective way to hedge equity returns and to diversify their portfolios.
It is also possible to invest in Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs) that track volatility. These hold VIX Futures contracts on your behalf and they mirror the VIX. ETFs and ETNs are an alternative option for short-term trades.
Gold – still a safe investment?
According to Bloomberg’s analysis presented in Make The Most Of Volatility, there is a strong correlation between the level of the VIX and the return that an investment in gold can provide.
The VIX moves in a limited range between 9 and 90. A level of 30 or more is considered rare. But when the “fear index,” as the VIX is known, spikes, an investment in gold could provide positive returns. Consider the following data:
- In the period between 2001 and 2011, the VIX crossed 30 only 18 times. On 17 of these occasions, gold purchases would have yielded a positive return over the next six months.
- If the time period from 2011 to February 2018 is considered, the VIX moved beyond 30 only once. That happened in August 2015, at the time of China’s surprise yuan devaluation. Again, gold provided a positive return in the next six months.
An investment in gold can help to protect your portfolio from market volatility. As an asset class, it has a low correlation with other investments.
Make The Most Of Volatility also provides guidance on the various methods that you can use to invest in the precious metal.
Trading oil in volatility
Fluctuating oil prices can provide an opportunity for making positive returns as well. There are several ways to do so if you are confident that you have the ability to correctly predict future oil prices:
- Futures – if you expect oil prices to rise, you can buy futures. If your analysis says that prices will fall, you can sell futures.
- Options – these carry a lower degree of risk when compared to futures.
- Contracts for Difference (CFD) – you can buy or sell a CFD and if the price of oil moves in the right direction, you can make a substantial profit. However, the leverage that you enjoy works the other way too. If the market moves in the opposite direction to your trade, your losses can be equally large.
Use volatility to your advantage
If you are a conservative investor who prefers the stock market, Make The Most Of Volatility offers a strategy that you can use when volatility rises. This is what the eBook mentioned:
A way to mitigate losses from volatility would be to trade in CBOE VIX Futures and VIX Options contracts to insure yourself from short-term losses.
Bloomberg’s eBook, Make The Most Of Volatility, also provides an excellent overview of various investment options. It contains a great amount of usable information and valuable insights just from reading this short and lucid book.