How to Love and Profit From Roller-Coaster Markets
If you're like many investors, you're probably getting a little sick of all the turbulence we've seen on Wall Street lately. Down 600 points, up 400, down 500, up 450 -- it's enough to make even those with the most intestinal fortitude feel a little queasy.
But as disheartening as it can be to see your portfolio flop all over the place from day to day, you can actually turn this unusual volatility to your advantage. Some investing strategies actually work better in crazy markets like this, and so making the most of these wild days while they last can help you feel a lot better about suffering through the big moves.
How not to get rich from volatility
One promising area for tracking volatility directly has come from the exchange-traded fund universe. Volatility ETFs promised to give investors direct exposure to the VIX, also known as the "fear index."
Unfortunately, the volatility ETF experiment has largely been a failure. The iPath S&P 500 VIX Short-Term ETN (NYS: VXX) , which tracks short-term volatility, has lost 85% of its value in the past two years as its futures-related strategy has intrinsic problems for investors who try to use it as a long-term volatility play. Alternatives like the iPath S&P 500 VIX Medium-Term ETN (NYS: VXZ) haven't suffered quite so much from futures-related friction, but they still haven't brought profits to long-term investors.
Moreover, many ETFs actually get hurt by volatility. Leveraged ETFProShares UltraShort S&P 500 (NYS: SDS) , for instance, jumped sharply in the first phase of the downturn, but all the ups and downs we've seen have eroded its expected double-inverse returns by nearly two percentage points in just 11 days.
Strategies that love risk
So if betting on volatility directly doesn't work, what does? Some more subtle strategies can work well when stock prices start bouncing around.
One is to use options-writing strategies. Many investors steer clear of options, believing that they're inherently risky and overly complex. But two simple options-writing strategies can give you increased payoffs when stocks are particularly volatile, because the prices of options go up in volatile market environments.
The first is the covered call strategy. With covered calls, you write call options on stocks that you already own. Selling the call option gives you a fixed payment upfront, but in exchange, you agree to give the option buyer the right to buy your shares for a certain price in the future. The danger of covered calls, though, is that if the stock price rises too far, you'll be forced to sell your shares -- something you may not be excited about with markets well off their highs. But for usually stable, predictable stocks, such as McDonald's (NYS: MCD) and Chevron (NYS: CVX) , a covered call strategy can enhance your income.
On the other hand, writing puts involves your accepting an upfront payment in exchange for agreeing to buy shares of stock from the put buyer at a certain price. If the stock price stays above the strike price specified in the option, then you won't get to buy the shares. But if shares fall, you'll get to buy them at the price you thought was attractive when you sold the put option.
The problem here is that in a free-falling market, you can get stuck paying a relatively high strike price even if you could get shares more cheaply on the open market. So stocks like Dendreon (NAS: DNDN) and American Superconductor (NAS: AMSC) , which dropped sharply in a short timespan, show how even a conservative put-writing strategy can backfire.
The simplest strategy
If you're just not comfortable with options, an even easier thing to do is to enter a bunch of limit buy orders at what may seem now like ridiculous prices. Sure, right now, a lowball offer may seem almost offensive. But if the market sees another eight-day plunge, even a bid well below today's market close could execute -- giving you the chance to cash in.
Volatile markets are hard to get used to. But given enough time -- and when you realize the profits it can generate -- volatility gives you one of the best opportunities you're likely to see in your investing life.
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At the time this article was published Fool contributorDan Caplingergot a little carsick just writing this article. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Fool has written naked calls on iPath S&P 500 VIX Short-Term Futures ETN. Motley Fool newsletter services have recommended buying shares of Chevron and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool'sdisclosure policymakes a great amusement-park ride.
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