[UNITED STATES] Most investors are aware that the market has both bull runs and downturns. So, what occurs during times of significant market volatility? Making the incorrect decisions might wipe out prior achievements and more. Using non-directional or probability-based trading approaches, investors may be able to safeguard their assets from potential losses while also profiting from growing volatility through particular strategies.
Recent market behavior underscores the importance of these strategies. For example, in early 2023, the collapse of several regional banks triggered a spike in volatility, catching many investors off guard. Those who had hedged their portfolios or employed non-directional strategies were better positioned to weather the storm, while others faced steep losses. Such events highlight how quickly market conditions can shift—and why preparation is key.
Volatility vs. Risk
Before settling on a trading strategy, you must first comprehend the distinction between volatility and risk. Volatility in financial markets refers to the pace and amplitude of an asset's price swings. Any asset whose market price fluctuates over time has some level of volatility. Volatility increases the size and frequency of these movements.
Risk, on the other hand, refers to the chance of losing part or all of an investment. There are various types of risks that can result in a loss, including market risk (the possibility that prices could move against you).
Interestingly, not all volatility is bad. For instance, earnings season often brings heightened volatility as companies report results, but this can also create lucrative opportunities for traders who anticipate earnings surprises. The key is distinguishing between short-term noise and long-term structural risks—something that requires both discipline and a well-defined strategy.
As market volatility grows, so does market risk. As a result, the volume of trades might grow significantly during certain periods, while the holding periods of positions decrease. Furthermore, hypersensitivity to news is frequently reflected in prices during periods of excessive volatility, as the market overreacts.
Thus, increasing volatility can lead to larger and more frequent downswings, posing market risk to investors. Fortunately, volatility can be hedged to some extent. Furthermore, there are ways to actively profit from increased volatility.
Hedging Against Volatility
Perhaps the most important thing for most long-term investors is to protect against potential losses when markets become volatile. One option to accomplish this is to sell shares or create stop-loss orders to sell them automatically when prices fall by a particular level. This, however, can result in taxable events and remove the investments from one's portfolio. For a buy-and-hold investor, this is frequently not the greatest strategy.
Instead, investors can purchase defensive put options on individual companies or on a larger index, such as the S&P 500 (for example, using S&P 500 ETF options). A put option gives the holder the right (but not the obligation) to sell shares of the underlying at a set price on or before the contract expires.
Another emerging tool for hedging is volatility-linked structured products, which offer downside protection while allowing participation in upside gains. These products, often tied to the VIX or other volatility benchmarks, have gained traction among institutional investors and are increasingly accessible to retail traders through certain brokerages.
Assume that XYZ stock is trading at $100 per share and you want to safeguard against losses greater than 20%. You can buy an 80 strike put, which gives you the option to sell shares for $80 even if the market falls to, say, $50. This basically establishes a pricing floor.
Trading Volatility
Investors who want to make a directional bet on volatility can buy or sell ETFs or ETNs that track the volatility index. One such indicator is the CBOE Volatility indicator (VIX), which measures the volatility of the S&P 500 index. The VIX, also known as the "fear index," increases in value as volatility rises.
You may also want to explore purchasing options contracts to profit from growing volatility while simultaneously hedging your losses. Options pricing are highly related to volatility and will rise alongside it. Because unpredictable markets can create swings both upwards and downwards as prices fluctuate, buying a straddle or a strangle is a common strategy.
It’s worth noting that while volatility trading can be profitable, it requires precise timing. The VIX, for example, is mean-reverting—meaning that after sharp spikes, it often declines just as quickly. Traders must be cautious not to hold positions too long, lest they miss the optimal exit point.
Non-Directional Investing
Most investors engage in directional investing, which needs the markets to move continuously in one direction (up for longs and down for shorts). Market timers, long or short stock investors, and trend watchers all use directional investing tactics. During times of extreme volatility, the market may become directionless or sideways, triggering stop losses on many occasions. Years of progress can be reversed in a matter of days.
Non-directional equity investors, on the other hand, seek to capitalize on market inefficiencies and relative pricing disparities. Importantly, non-directional techniques, as the name implies, are unconcerned with whether prices rise or decrease, and may thus thrive in both bull and down markets.
Equity-Market-Neutral Strategy
The equity-market-neutral strategy is based on the idea that your returns will be more closely related to the difference between the best and worst performers than to overall market performance—and hence less vulnerable to market volatility. This technique entails purchasing comparatively inexpensive stocks while selling relatively overvalued stocks that are in the same industrial sector or look to be peer companies. It so aims to profit from differences in stock prices by holding an equal number of long and short positions in closely connected stocks.
This is where stock pickers may excel because the ability to select the appropriate stock is all that matters with this method. The idea is to profit from price discrepancies by having long and short stocks in the same sector, industry, country, market capitalization, and so on.
Focusing on pairs of stocks or a single sector rather than the entire market emphasizes activity within a category. Consequently, a loss on a short position can be quickly offset by a gain on a long one. The difficulty is to distinguish between exceptional and underperforming stocks.
Merger Arbitrage
The stocks of two firms involved in a proposed merger or acquisition frequently react differently to the announcement of the imminent move, and the companies aim to capitalize on the shareholders' reaction. Often, the acquirer's stock is reduced while the stock of the company being bought appreciates in anticipation of the takeover.
A merger arbitrage strategy seeks to capitalize on the fact that the combined equities typically trade at a discount to the post-merger price due to the possibility that any merger may fail. In the hopes that the merger would go through, the investor buys the target company's stock while shorting the acquiring company's stock.
Relative Value Arbitrage
The relative value strategy looks for a correlation between securities and is commonly utilized in a sideways market. What types of pairings are ideal? They are heavyweight equities in the same industry with extensive trading history.
Once you've found the similarities, it's time to wait for their courses to separate. A divergence of 5% or greater for two days or longer indicates that you can open a stake in both equities with the hope that they will eventually converge. You can long the inexpensive stock and short the overvalued one, then close both bets once they coincide.
What Causes Market Volatility?
In general, market volatility rises when investors are fearful or uncertain. Either can be the result of an economic slowdown or a reaction to geopolitical events or calamities. For example, market volatility increased as a result of the 2008-09 credit crisis, which triggered the Great Recession. It also rose sharply after Russia invaded Ukraine in 2022.
More recently, volatility has been influenced by macroeconomic factors such as interest rate hikes by central banks, inflationary pressures, and shifting expectations around corporate earnings. These factors create an environment where even minor news can trigger outsized market reactions, reinforcing the need for robust risk management strategies.
What Investments Track the VIX Volatility Index?
VIX futures trade on the CBOE and are available to customers of certain brokerages. For people who do not have access to futures, there are ETFs and ETNs available, such as the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX), the iPath Series B S&P 500 VIX Mid-Term Futures ETN (VXZ), and the ProShares VIX Short-Term Futures ETF (VIXY).
What Is Probability-Based Investing?
In addition to hedging, fundamental analysis can help you understand the risk of a specific investment. Even in today's liquid and somewhat efficient markets, there are situations when one or more critical pieces of data about a company are not broadly distributed, or when market players interpret the same information differently. This can lead to an inefficient stock price that is not reflected in its beta. Holders of that stock are so tacitly accepting greater risk, of which they are likely unaware.
Probability-based investing is one technique for determining if this factor applies to a specific company or security. This method allows investors to compare the company's real financial facts, such as current cash flow and historical growth, to the market's expectations for future growth. This comparison aids in calculating the chance that the stock price accurately reflects all relevant information. Companies that meet the requirements of this analysis are thus regarded more likely to achieve the future growth level that the market believes them to have.
In a volatile market, the first thing you should do is take a step back and consider why you are investing. It's difficult not to panic when the market falls or to act like an ostrich and do nothing, but neither will help you achieve your objectives. Market volatility creates more opportunities for profit in a short period of time, but it also increases risk.
Ultimately, the most successful investors during volatile periods are those who stick to their strategies, remain disciplined, and avoid emotional decision-making. Whether through hedging, volatility trading, or non-directional approaches, the key is having a plan—and the patience to execute it effectively.
WhatsApp
Instagram
Threads
