Everybody knows that the market can undergo extremely volatile periods. During such times, making the wrong moves can erase previous gains and more. The following strategies can help investors protect their investments when such times come.
Volatility and Risks
But before you choose your trading methods, you need to understand first the difference between volatility and risks.
In the financial markets, volatility refers to the extreme and rapid price swings. Meanwhile, risk refers to the chances of losing a part or all of your investment.
When volatility in the market spikes, your profit potential also increases. At the same time, your chances of losses also go high.
During highly volatile times, there’s a markedly higher trading volume. Also, there is a hypersensitivity to news, and this is often reflected in market prices.
Investing According Probabilities
Even though theory suggests that stock market prices efficiently reflect all available information at a time, there may still be some pieces of information or more that are not reflected.
This can lead to an inefficient stock price that’s not reflected in the data. Thus, the investor is facing additional risks and he doesn’t even know it.
Investing according to probabilities is a strategy to use to determine whether this factor applies to a particular stock or security.
The investor compares the company’s growth as expected by the market with the company’s actual financial data, such as cash flow and historical growth.
Directional vs. Non-Directional Strategy
Most private investors use directional investing, which is a strategy that needs the markets to move consistently in a particular direction that can be either up or down.
Traders and investors who use directional investing are often market timers, long or short equity investors, and trend investors.
When volatility spikes, the market may become directionless and chop sideways, which could repeatedly trigger stop loss orders.
Meanwhile, non-directional strategies are those that try to take advantage of market inefficiencies and relative pricing discrepancies.
In this strategy, the investors’ skill in picking the right stock matters the most. The goal is to leverage the differences in stock prices by being both long and short among the stocks in the same sector, industry, country, or market capitalization.
When you focus on the sector and not the market as a whole, you are highlighting a movement within a category. Therefore, any losses on a short position can be quickly offset by any gain on the long side. You just have to find the standout and the underperforming stocks.
Investors have also noticed that the stocks of companies that are participating in a merger or acquisition usually react differently to news of the impending action, trying to take advantage of the shareholders’ reaction.
Usually, the acquirer’s stock is discounted while the stock of the company that is being acquired increase in value because of the buyout’s anticipation.
In a merger arbitrage strategy, the goal is to take advantage of the fact that the stocks combined often trade at a discount to the post-merger price because of the chances of the deal falling apart.
With the hopes that the merger will close, the investor will simultaneously buy the target company’s stock and shorts the acquiring company’s stock.