There are numerous reasons for volatility in the stock market and it should be accepted as the underlying reality of investing.
As an asset class, stocks are volatile by nature. There are numerous reasons for volatility in the stock market and it should be accepted as the underlying reality of investing. Unless there is a market-wide consensus of the future, a trend cannot be in place and until a trend is in place, markets will always be volatile. Every trader/investor should be equipped with strategies to make profits in such uncertain scenarios. Here are the top five ways to make money in a volatile market:
1. Options Strategies – There are several ways of making money in volatile scenarios using options strategies. Some popular strategies include short straddles, short strangles, iron condor, covered call etc. Any strategy which involves selling either at the money or Out of The Money (OTM) or At The Money (ATM) options with an expectation that the market direction will not change much and the options premiums will decay significantly or expire worthlessly, thereby generating profits for the writer. Selling options in volatile scenarios can be very tempting but it is extremely important to be hedged, otherwise, the downside could be higher if you are wrong. 4 legged options strategies such as Iron Condor and Iron butterfly give you the perfect hedge. It is a good strategy to enter these strategies across different stocks with low correlation so that you have a higher probability of success. A covered call is a very effective and yet simple strategy that works very well. In fact, it is designed to make the maximum amount of money in moderately volatile markets where the price of the underlying is within a tight range and the options premiums are high. Executing covered call strategy successfully over a period of time helps generate extra returns on a stock.
2. Have a long & short exposure – When there is no clear direction and when the market can go either way, it is not always sensible to have a 100% long-only portfolio. It is much wiser to have a percentage of your capital in short trades. The ideal case would be if you are long strong/bullish stocks and short weak/bearish stocks during the volatile phase. When going short, choose the weakest stocks from the weakest sectors. Generally, despite having fallen a lot already, their downtrend will continue if the overall market sentiment is uncertain. This is a rule of thumb but must be exercised with caution as shorting requires a level of skills that can be skillfully executed by active traders only. While having a short exposure, it is extremely important to be aware of the range of stocks as entering trades at the wrong prices can completely disrupt the profit potential. The long/short ratio should depend on your outlook of the market. For instance, if you are moderately bullish, then the long/short ratio should be in the range of 65:35 or so. A balanced approach such as this will help play market fluctuations more effectively. If you are not savvy with these concepts, it is best to withdraw a certain portion of your long portfolio and park in a less correlated asset class such as gold or fixed income.
3. Rupee Cost Averaging – Contrary to popular wisdom, averaging your positions can be very beneficial during volatile markets. Averaging is good, but averaging with leverage is a sin. Leverage changes the equation dramatically because the margin of error reduces substantially and also the waiting power is extremely limited. Hence, the odds are stacked against a trader who averages against the trend with leverage. That aside, if you can buy equity every time the market corrects within a range, then you will accomplish lower buy averages and that’s a good thing for your portfolio.
There are two ways of doing this; you can either sell your existing holdings at the highs and re-purchase them at lower prices and play the range or you can infuse additional capital which can help improve the average purchase prices. If you can do this successfully, you will be operating within a margin of safety as long as the markets are within a range. A classic example is SIP investments during volatile markets is a great strategy.
4. Trade within the range – Although most gurus & mainstream television panelists may oppose this, as a trader you could make a lot of money if you are able to identify the range in which the volatility exists & successfully trade within it. Buy at the lower and of the range and sell at the upper and of the range. You could also short at the upper range and cover your profits at the lower range if you are adept at switching positions without getting emotional about them. More often than not, volatility is a boon for active traders because as long as the market moves, there is profit potential. In my experience, it is during these times that traders tend to make the maximum amount of money. The scope for technical analysis arises when the market moves in a range and gives an opportunity to the participants to maneuver their trades.
Also, an unconventional way of trading options within a range is to leg-in & leg-out of the option strategy. For instance, if you want to enter an iron condor sell call options when the market has reached the upper end of the range and take the opportunity to buy OTM put options. When the market goes down to the lower end of the range, you can sell at the money put options and buy OTM call options, thereby entering an Iron Condor in phases rather than at once. The advantage of doing this is that your entry prices will give you a better profit to loss ratio. Not everyone can do this, but it’s definitely worth a try for active traders.
5. Invest in another asset class – Timing the market is not easy and if you are not confident about taking advantage of volatility, you should avoid it. Take the opportunity to move out of equities and invest in debt until an upward trend is established. You can re-enter the market when there is more certainty. This is the approach used by investors who are either unskilled in trading or don’t want to be involved in the daily fluctuation of stock prices. This approach is common and usually more peaceful.
All of the above strategies are meant for those who thoroughly understand the basic concepts of trading, derivatives, position sizing and overall money management. It is important to have a capital size that allows you to execute the above strategies in multiple stocks. Diversification in trading helps deal with random spikes and noise. Traders with a smaller capital will need to be nimple with their trades as position sizing and money management can become tricky.
(By Tejas Khoday, CEO and Co-Founder, FYERS)