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Today, I want to briefly define volatility, show the easiest way to track it, and demonstrate how you can take advantage of other investors’ fears in any market.
Now, I don’t want to get too technical. But you must understand what volatility is and how it works.
Volatility can be the result of sharp price increases or decreases over a short period of time. Therefore, when prices are stable or increasing/decreasing by small amounts, this is when we say that “volatility is low.”
The speed of price movement and the rate of change in asset prices in either direction is unpredictable.
When there is more speed and greater rates of change, this is known as increased volatility.
Whether you’re new to investing or a seasoned pro, the term “volatility” is commonly associated with “fear” — especially when stock prices fall by several percentage points in a matter of days.
But I’d argue that it really should be associated with “opportunity.”
The most important thing to remember is this: Markets require price movement, and that is where you find opportunity.
You can’t make money if stock prices don’t change. And you’ll have a very dull — and pointless — stock market if everything just stays the same. So, when significant movement starts to happen, the trick isn’t to panic. Instead, the trick is to recognize how you can take advantage of the situation.
How Do I Know When Volatility is Increasing?
Before we get to the opportunities, let’s just talk about how you’ll know when volatility is on the move. You can look at a stock chart or the S&P 500 and see big moves over short periods. Daily price movements impact market volatility.
According to Adviser Investments, a daily move of 0.66% on the S&P 500 will typically generate headlines. However, other experts will state that you want to pay attention to the number of days the S&P 500 goes up or down by 1% or more. On average, the S&P 500 moves by those levels about 52 times each year. This is a common way to measure historical volatility and gives investors the ability to estimate future events based on historical patterns.
However, we also want to keep tabs on the market’s current pulse. The surefire way to follow market volatility is by using a tool called the “VIX,” or the CBOE Volatility Index. This forward-looking index is considered the market’s “fear gauge” for a reason. It is a measurement of how investors expect the S&P 500 to perform in the next 30 days.
So, if you followed the VIX on Monday afternoon, it sat at 18.14.
By 10:30 a.m. on Tuesday, it surged by 32.5% to 24.03.
CNBC’s bottom third of the screen blazed about surging volatility. Investment blogs and financial newspapers wailed about a number of negative catalysts that might hurt investor sentiment: The Federal Reserve, the debt ceiling, Chinese property debt, supply chain problems, and much more.
Many investors sold off their stocks due to a huge wave of worry about greater uncertainty and fear in the market. We had sharp pullbacks in the S&P 500 in recent days.
So, when you hear the term “implied volatility” — which the VIX measures — know that it is a measurement of expected future volatility in the market.
How to Take Advantage of Volatility
Market uncertainty and fear drives volatility. We can see volatility rise during major macroeconomic events, like a meeting of the Federal Reserve over interest rates, increasing geopolitical tensions, surging or falling commodity prices, or an unexpected event that suddenly makes investors worried about the market for the next 30 days.
Historically, when the VIX rises, the S&P 500 will decline, meaning that a sell-off can occur or fewer investors will buy stocks and move to other safe-haven assets like gold, bonds, or currencies like the yen or Swiss franc. An uptick in volatility also correlates with larger short-term losses as many investors head for the exits.
The problem, unfortunately, is that investors who sell based on short-term fear historically underperform the markets. So instead of selling, longer-term investors should take advantage of this fear. Remember, stocks need to move so that you can make a profit.
So, when you hear the term “buy the dip” during a sell-off, you’re taking advantage of volatility and investor fear. This allows you to exploit the long-term upward bias of the markets.
But there’s another way to exploit volatility. When implied volatility increases, it impacts the value of options contracts. So on Monday, I will explain how you can take even more significant advantage of volatility to generate gobs of income and pick your preferred entry price for any stock with an options chain.
Until then, ignore the fear. We’ll learn how to exploit volatility all week long.