market volatility, credit crunch

How to profit from market volatility

25.01.2008

by Tim Bennett

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“We are certainly in a period of extreme volatility right now,” Scott Murphy of Hardesty Capital Management told Bloomberg with masterful understatement this week. Monday’s collapse in share prices was just the latest spasm to rack stockmarkets, which have seen far more extreme movements in recent months than investors have been used to.

Indeed, as The Economist points out, only a year ago volatility seemed to be a relic of the past as share prices rose serenely. Investment banks claimed that new derivative instruments could dissipate risk, minimising market mood swings.

But August’s credit crunch exposed this as the wishful thinking it always was. The good news is that, if you understand volatility, you can protect your investments – or even profit from it.

Measuring volatility

Volatility may seem like an abstract concept, but you can in fact measure it. The Chicago Board Options Exchange’s S&P 500 volatility index, or “Vix” (also known as Wall Street’s “fear gauge”), looks at the price investors are paying to insure stock portfolios against sudden changes in the S&P 500.

There are two basic types of option. “Calls” give an investor the right to buy (“call over”), while “puts” give them the right to sell (“put away”) an asset for a fixed (“strike”) price on, or before, a preset date. Although valuing options is complicated – the first people to crack it properly were Nobel prize winners – the basic principles have been around for centuries.

Say you’re a fund manager, worried that a sharp fall in the S&P 500 over the next three months will drag down the value of the US stocks in your portfolio. You could sell them all. But it would be easier and cheaper to buy a put option on the index. This would give you the right to claim a single cash pay out – on or before a specific date – which would grow the further the index falls below the pre-agreed strike price. Just like an insurance policy, the option expires once the cover period ends. Should the S&P index rise during that time, all you’ve lost is the original cost of the option.

A key ingredient in determining how much you have to pay for an option is the assumed, or “implied”, volatility over the term of the contract. As you might expect, the more volatile an asset is expected to be, the more you get charged for options on it. For example, technology firms’ profits are less stable than earnings for utility firms, which in turn makes the associated options more expensive.

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The Vix, as Seeking Alpha puts it, approximates this variability for the stocks in the S&P 500, giving investors a broad overview of just how stormy conditions are in the market. Anything much over 30 is considered “extreme”. This week the Vix went as high as 37.5.

Why has volatility spiked now?

Due to the credit crunch, future company earnings, and thus share prices, have grown harder to predict. So options have become more expensive as extreme share-price movements become more common. But several factors have made the problem worse. First, as with car insurance policies, over the long term most options contracts are never cashed in. So sellers often earn up-front premiums for doing little. Given the chance to make apparently easy money, investment banks have piled into selling options in recent years. Competition drove premiums (and hence the Vix index) to well-below average levels.

But when August’s credit crunch hit home, sending the Vix from around 15 to more than 30 in less than a month, the firms that had written cheap cover got burnt and several stopped writing new contracts altogether just as demand started to soar, resulting in a mini “options crunch”. Furthermore, as The Economist observes, since its creation in 1993 the Vix gauge has averaged a reading of 19, but in recent years has run “at only 70% of its historical average”. So what we are seeing is in fact a long overdue correction to the mean.

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Investing in volatile times

For risk-takers there are a couple of ways to make money from equity volatility. First it is possible to place up and down bets on the Vix itself by buying or selling Vix futures through a broker such as Finspreads. These work in much the same way as spreadbets and so it’s vital to use stop-losses to limit any losses if you get the direction of the bet wrong.

Alternatively, there are exchange-traded funds available that enable you to short-sell indices, such as the Proshares Ultrashort S&P 500 (AMEX:SDS). This offers returns of twice the inverse performance of the S&P index – ie, if it falls 10%, you make 20%. Although this isn’t a trade on volatility as such, the ability to go short can be useful during volatile times.

For more wary investors, high volatility is probably a good reason to keep a large chunk of your portfolio in cash. Extreme moves can open up opportunities, but often they are just a precursor to larger falls. A safer time to go bargain hunting could be when the Vix next settles down – and given the shocks still waiting to hit the financial sector, that could be a while.

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