In addition to bringing down Lehman Brothers and other “too-big-to-fail” financial institutions, the market collapse of 2008 launched an era of incontrovertible economic uncertainty. The subsequent ripple effect of the downfall–triggered by the liquidity crunch, the sub-prime mortgage crisis, and a bevy of other convergent factors, continues to be felt today. While indicators like the recent 6.6% jump in Black Friday sales following months of up-and-down U.S. consumer spending patterns suggest early recovery, other post-crisis macroeconomic news and events routinely jolt The Street back down a peg.
Take, for example, the S&P’s recent decision to downgrade its long-term U.S. credit rating from AAA to AA, provoking an unprecedented four triple-digit swings within a five-day period, during which the Dow Jones Industrial Average would drop 4% one day, only to spike 4.2% the next. While this scenario represents the extreme end of the volatility spectrum, it nevertheless illustrates how market volatility is poised to stick around-at least for a while, anyway. Yet this doesn’t necessarily mean a bleak picture for investors. On the contrary: a well-executed portfolio exploits the very market swings that typically strike fears in investors, can win enviable returns, regardless of the economic climate we are in.
Multi-Pronged Approach
Capitalizing on volatility demands a comprehensive strategy that plays on several different key elements. In addition to utilizing quantitative investment models that rely on stop limits to lock in profits, managing volatility substantially involves portfolio reallocation into high-yield, high dividend-paying companies that are likely to maintain growth over the long haul. Pipeline companies, food companies like B&G Foods (BGS), and tobacco companies like Altria Group (MO), tend to demonstrate significant price inflation that allows investors to lock in dividends ranging between 4% and 8%–yields significantly above U.S. Treasury Bills. By cheaply purchasing stocks with strong income statements momentarily depressed by unsteady markets, almost any type of investor stands to gain-from retirees, to those nearing retirement, to younger folks with decades to go before reaching their golden years, who are looking to build a “safe deposit box full of dividends” for when that day arrives. Simply: the strategy is buying or adding to positions, with strong fundamentals, already held in a portfolio when the market is volatile. This can be done with limit orders or carefully crafted strategies to acquire blocks of stock in each portfolio.
Well “Oiled” Machine
An ever complex game of interdependency between physical and financial markets, where market manipulation and investor sentiment can cause erratic sell offs, investing in the oil energy sub-sector has always held built-in profit opportunities. And when fundamentals collide with sentiment, margins expand greatly. If a position is fundamentally strong, “buy” when the position is trading within a range and “sell” towards the upside of the range. Sometimes, going against popular opinion is beneficial. Today’s climate introduces no better time to put this phenomenon to the test.
Within a mere decade, the price of crude oil jumped from a relatively-stable $22-$28 dollars per barrel in the early 2000s, to more than $100 from 2004-2008, peaking at $145 before backsliding 25% in the short span of a quarter, to $100 today. Such swings provide fertile ground in which to reap the benefits of trading volatility, by positioning investors in leveraged ETFs such as ProShares UltraShort DJ-AIG Crude Oil ETF (SCO) or ProShares Ultra DJ-AIG Crude Oil ETF (UCO), which presents an enticing, efficient method of straddling the oil market by diversifying into multiple positions. Selling off portions of a shareholder’s stock position using short-term, long-term and mid-term price points allows investors to rest comfortably, knowing that quantitative trading methodologies and discipline are helping to deflect harm potentially caused by kneejerk investors who recklessly divest based on pure emotion-a concern that will become increasingly evident the further along we get into election season, where people vote with their wallets long before casting their ballots at the polls. Range trading allows the investor to play the volatility as an efficient strategy.
Risk arbitrage heavily factors into the mix as well, where with a leveraged index, a drop in oil prices of two or three dollars per barrel effectively lets investors buy in at a 6% discount. Finally: limits represent the final piece of the oil puzzle. A client with a 2000-share position who facilitates an initial limit order on 1000 shares, a second limit order on the next 500 shares, and a third order for the final 500 shares, is essentially trading within the mean reversion.
Simply put: an actively managed volatility trading program, entailing 5% or 10% of an investor’s portfolio, is a viable approach for almost anyone. Let volatility be your friend.
The Conundrum
Volatility unquestionably can be harnessed for good. But boarding investors on the volatility train can be easier said than done–especially for those individuals who must unlearn years of incorrect thinking, often unfortunately taught to them by less-than-stellar advisors who have stigmatized volatility as the boogeyman, spooking investors into taking overly-conservative positions that can remove too much risk and diminish long-term return potential. And while it’s important to recognize that a well-managed risk reduction campaign is essential to successful investing, used intelligently volatility can allow investors to thrive.