Profit From Volatility
After a relatively smooth upward climb over the past nine years, volatility has come roaring back to the markets. I commented to a friend recently that the first quarter was brutal, and he said: “Oh, and how much were the indices down in the quarter?”
He has a point, which I will get to below, but my point was about volatility.
A Smooth Ride
I posted the following graphic in the recent article Nine Years Of Bull to put the recent market swings into perspective:
Overall, there have been some corrections during the past nine years, but it’s been a relatively smooth period.
But the market became more volatile in the first quarter. Let’s look at that graphic for the past year to highlight how wildly things began to swing in Q1:
But my friend’s point was, despite all of that volatility the S&P 500 was only down 2% in the first quarter. Of course, that’s not much consolation for investors who sold in a panic as the S&P 500 lost more than 10% in early February.
I count myself among those concerned about the spike in volatility. For me, it signals that the chance of more 10% or more flash crashes in the near term is growing.
Use Volatility to Your Advantage
But the positive side of that volatility is that it allows investors to buy quality companies that have become overvalued. I can’t tell you how often I have looked at an Apple Inc. (NASDAQ: AAPL) or an Intel Corporation (NASDAQ: INTC) or a Pfizer Inc. (NYSE: PFE) and thought — I would love to pick that up at a 10% discount.
Opportunities like that on quality companies often present themselves only during these violent market swings. Sure, I could have bought Apple in January for $175 a share. But I wanted it for $160 a share.
Guess what? I got it for that. Then I sold it a month later at $175 a share. I didn’t get the lows on that cycle (who would have believed I could have gotten it for $155 a share?) or the highs (~$180 a share), but I did manage to turn a profit in a whipsaw market.
Keep Some Powder Dry
Here’s the thing. I always keep a little cash in reserve for that rare opportunity to pick up quality companies at dream prices. At any one time, I have maybe a dozen limit orders out for great companies at deep discounts to their current values.
Most of the time the orders don’t trigger. It may be asking a bit much to pick up Applied Materials (NASDAQ: AMAT), which is currently trading at $52, for $40. But if the market plummets, I have a limit order at that price waiting to execute.
There is one risk in this approach, and that is if there is a huge one-day drop in the market. If you have too many of these “dream price” limit orders open, a steep stock market drop like the 22.6% drop of Black Monday in 1987 could see them all execute at the same time. So, be sure you have enough cash in reserve to cover such a rare event.
Shorting With Options
Of course, this strategy works both ways. I explained in Safely Betting Against Tesla that I also like to short companies that I believe to be overvalued, but I like to catch them spiking upward on volatility.
Going short, however, can be quite risky. So as I explained in that article, I utilize a modified strategy with options that protects me against unlimited losses should the stock price soar.
Editor’s Note: Options can also be used to safely generate steady income during periods of market volatility as explained HERE.