Volatility: Friend Or Foe?

Investing in volatile markets can be a risky business, and it's important to understand the potential pitfalls. Volatility refers to the amount of uncertainty or risk related to the size and speed of changes in an asset's value. In securities markets, volatility is associated with big price swings up or down. When the stock market rises and falls more than 1% over a sustained period, it is considered a volatile market. Volatile assets are considered riskier because their prices are less predictable.

There are a few things to consider when deciding whether to invest in volatile markets. Firstly, it's important to take a long-term view. Markets typically fluctuate, and even bear markets tend to be relatively short compared to bull markets. Secondly, it's crucial to review your risk tolerance and capacity. Volatile markets can highlight the need for a diversified portfolio, as they can reveal that portfolios are not as diversified as their owners thought. Adding defensive assets, such as cash, cash equivalents, and government bonds, can help stabilise a portfolio during volatile times.

It's also worth noting that investors with different profiles may have different approaches to volatility. For example, investors nearing or in retirement may want to add defensive assets for stability, whereas long-term investors are generally advised to ignore short-term volatility and stay the course.

In conclusion, investing in volatile markets requires careful consideration of your financial goals, risk tolerance, and investment timeframe. It is not a decision to be made lightly, and it is always a good idea to consult a financial professional before making any significant investment decisions.

Volatile markets and emotional reactions

Volatile markets can be distressing for investors, with prices fluctuating wildly or falling suddenly. Emotional reactions to these short-term market movements can put investors at risk of further financial losses. It is important to remember that markets like consistency, and when there are many surprises, the market will not behave.

During volatile markets, investors may feel the urge to sell based on recent market movements. However, selling stocks when the market drops can make temporary losses permanent. While it is emotionally challenging, staying the course may be healthier for your portfolio. It is important to take a long-term view and remember that markets typically go up and down, and even bear markets are usually relatively short compared to bull markets.

To avoid emotional reactions to volatile markets, investors should focus on their financial plan and make decisions based on their goals and timetable rather than emotions or panic. It is also crucial to determine your risk tolerance and know how much risk you are willing and able to take. Risk tolerance refers to your ability to emotionally handle big price swings, while risk capacity is your financial ability to take a loss.

Additionally, it is essential to have a diversified portfolio with investments spread across different asset classes, such as stocks, bonds, and cash. Each asset class can respond differently to movements in the overall stock market, helping to mitigate the impact of volatile markets.

In summary, volatile markets can evoke strong emotional reactions from investors. To make rational decisions, investors should focus on their financial goals, understand their risk tolerance, and maintain a diversified portfolio.

Volatility and risk

The relationship between volatility and risk is important to understand when deciding on an investment. Highly volatile investments can carry greater risk and be detrimental to short-term goals. Volatility is more crucial in the short term, as it has less impact on long-term investments. For instance, stocks are generally considered riskier than bonds but tend to offer better returns. U.S. Treasury bonds are among the lowest-risk investments but typically provide a low rate of return.

It is essential to determine your ideal investment risk or "risk tolerance." This depends on factors such as your financial situation, goals, and emotional tolerance for price swings. If you are uncomfortable with market volatility, a low-risk portfolio may be more suitable. However, if you have a high risk tolerance and can afford potential losses, taking on more risk may lead to higher investment profits.

To manage volatility and risk effectively, consider the following strategies:

• Long-term perspective: Volatility is often less concerning for long-term investors as short-term price fluctuations tend to even out over time.
• Diversification: Invest in a diverse range of securities and asset classes that are uncorrelated. This helps balance risk and return, as the positive performance of some investments can offset the negative performance of others.
• Asset allocation: Adjust the percentage of different asset classes in your portfolio based on your risk tolerance. As you approach retirement, typically reduce equity exposure and increase investment in less volatile options like bonds.
• Don't time the market: Avoid the temptation to buy or sell based solely on recent market movements. Riding out the volatility and staying invested can help avoid locking in losses and paying higher prices later.
• Understand fundamental value: Volatility is based on market perceptions, not intrinsic value. A drop in stock prices may offer a buying opportunity, but only if you understand the underlying value of the asset.

Volatility and options pricing

Volatility is a key factor in options pricing. Options are financial derivatives that give the holder (buyer) the right to buy (call option) or sell (put option) an underlying asset at an agreed price on or before a specified date. The option seller (writer) is paid a premium by the buyer, who can either exercise the option or let it expire worthless. The premium is the option's price, often referred to as the intrinsic value, and is affected by several factors, including volatility.

Volatility refers to the fluctuations in the market price of the underlying asset. It is a metric that measures the speed and amount of movement in the underlying asset's price. Understanding volatility allows investors to comprehend why option prices behave in certain ways.

There are two main types of volatility relevant to option prices: implied volatility and historical volatility. Implied volatility (IV) is a prediction made by market participants about the degree of future price movements of the underlying asset. It is the real-time estimation of an asset's price as it trades and tends to increase when the options market experiences a downtrend. Conversely, market uptrends usually cause implied volatility to fall. Higher implied volatility indicates a greater expectation of option price movement in the future.

Historical volatility (HV), also known as statistical volatility, measures the speed of underlying asset price changes over a given time period. It is often calculated annually but can also be calculated daily or for shorter time frames. Generally, a higher historical volatility percentage results in a higher option value. However, the long-run volatility of a security tends to revert to a fundamental average level, suggesting that high observed volatility will fall, and low volatility will rise over time.

As volatility increases, the prices of all options on the underlying asset—both call and put options and across all strike prices—tend to rise. This is because the likelihood of all options finishing in the money also increases. Volatility is positively correlated with an option's price since larger price movements of an underlying asset increase the chances of an in-the-money option. Therefore, volatility plays a crucial role in options pricing.

Trading Strategies

Sheldon Natenberg's book, "Option Volatility & Pricing," is a widely recognised guide for option traders. It covers various topics, including volatility and directional trading strategies, stock index futures and options, and volatility contracts. Natenberg provides insights into how professional option traders approach the market, including the trading strategies and risk management techniques necessary for success.

Traders can profit from increasing price volatility by buying options. As markets become more volatile, they may move up or down, so buying a straddle or strangle (which are indifferent to market direction) can be a profitable strategy. Conversely, in a stable market or during periods of declining volatility, traders can profit by selling options and collecting the premiums. However, selling unhedged options (naked) can be highly risky.

Volatility and defensive assets

Defensive assets, such as cash and cash equivalents, Treasury securities, and other U.S. government bonds, can help stabilise a portfolio when stocks are slipping. Defensive stocks, including stocks with relatively low volatility or high quality, and investment-grade bonds, have historically seen smaller losses during down markets than lower-quality stocks or bonds.

Defensive stocks, such as those of well-established companies like Procter & Gamble, Johnson & Johnson, Philip Morris International, and Coca-Cola, provide consistent dividends and stable earnings regardless of the state of the overall stock market. They are less susceptible to factors that affect the rest of the stock market and are much less risky, but gains are not likely to be as substantial, particularly during bull markets.

Defensive portfolios may reduce losses in a down market but won't eliminate them. They aim to limit losses in a down market but will typically trail in a strong upmarket. Over longer time periods, a defensive portfolio captures much of the growth of the market, but with a smoother ride.

Defensive portfolios go a step beyond asset allocation by targeting specific securities with characteristics that have the potential to help smooth out investment potential. For example, within a bond portfolio, a fund manager might select securities that can offer protection from specific risks that seem relevant for a given market environment. In a higher inflation environment, Treasury inflation-protected securities (TIPS) might help protect the value of a fixed-income portfolio. In a low-growth, low-inflation environment, a mix of investment-grade bonds might offer protection from credit risk.

High-quality bonds may generate positive returns during equity downturns. Intermediate-term US treasuries, an example of high-quality bonds, tend to move in the opposite direction of stocks during significant and sustained stock market declines. When stocks fall sharply and trend lower, US treasuries often rise.

Conservative stocks tend to display a smaller degree of price movement than the broader stock market. Minimum volatility stocks, an example of conservative stocks, tend to be associated with companies that have relatively stable businesses. Historically, minimum volatility stocks hold up better when the broader stock market falls. During up markets, when broader stock market returns rise sharply, minimum volatility stocks also tend to rise, but more modestly than the broader stock market.

Volatility and long-term investing

Volatility refers to the amount of uncertainty or risk related to the size of changes in a security's value. It is a statistical measure of the dispersion of returns for a given security or market index. In the securities markets, volatility is often associated with big price swings either up or down.

Periods of market volatility can be unnerving for investors, but they are a normal feature of long-term investing. While it can be difficult to sit still when the market is sliding, it is important to resist the urge to sell based solely on recent market movements. Selling stocks when markets drop can make temporary losses permanent. Instead, investors should take the long view and focus on their financial plans and goals. Markets typically go up and down, and even bear markets have historically been relatively short compared to bull markets.

Diversify your portfolio

Having investments spread across different asset classes, such as stocks, bonds, and cash, is important because each can respond differently to movements in the overall stock market. Diversification can help mitigate the impact of volatile markets. It is also important to regularly review your portfolio to ensure it is appropriately diversified and that the mix matches your target asset allocation.

Determine your risk profile

Investing involves taking risks, and it is crucial to be honest about how much risk you are willing to take with your money. Determining your risk tolerance informs how you should diversify your investment portfolio between stocks, bonds, and cash. If you need your portfolio to generate income in the short term, consider a lower-risk portfolio. If your goals are long-term, you have more time to withstand and recover from volatility.

Take advantage of buying opportunities

Some investors can use volatility as an opportunity to add to their portfolios by buying during dips when prices are relatively cheap.

Use hedging strategies

You can also use hedging strategies to navigate volatility, such as buying protective puts to limit downside losses without having to sell any shares. However, it is important to note that put options will also become pricier when volatility is higher.

Stay the course

Long-term investors are advised to ignore periods of short-term volatility and stick to their investment plans. Over the long run, stock markets tend to rise, and emotions like fear and greed can undermine your long-term strategy.

Frequently asked questions