U.S. markets swung wildly on Thursday, with the Dow Jones Industrial Average dropping more than 600 points before roaring back late in the day to finish in the black, the third remarkable trading day in what is usually a quiet Christmas week.
Thursday’s gyrations came three days after U.S. markets experienced their worst Christmas Eve on record, with the Dow on Monday dropping 653 points and the S&P 500 falling 65, and one day after the Dow surged more than 1,000 points — or nearly five per cent — to post its biggest single-day point gain ever.
“The market is right now in a psychological frenzy, both good and bad,” David Katz, chief investment officer at Matrix Asset Advisors in New York, told Reuters. “There’s fear of the market going down; there’s fear of missing the rebound.”
The extreme moves, coming on the heels of significant correction in North American equities, have added stomach-churning volatility to the obstacles facing investors heading into 2019.
”It becomes extremely challenging when we enter bear markets like we have for people to … (stay) the course and put more money into markets on the opportunity,” said Chris Kerlow, a Richardson GMP Asset Management portfolio manager. ”We’re instinctively hard-wired to run away from the lion but in this situation you almost have to run at it.”
That can mean embracing the chaos and betting on the violent swings themselves.
Though it’s risky and experts suggest that it should be a “no-fly zone” for retail investors, buying into the volatility of the markets by investing in the Cboe Volatility Index is an option for some investors. The VIX index works as a fear gauge of sorts to the Street’s sentiment on the S&P500’s intraday trading. Generally, when stocks are highly volatile and are suffering, the VIX index rises and it drops down as soon as those same stocks rise again
Investors may gain exposure to the index either through investing directly in options and futures — typically either one or two months ahead.
“I think it’s a reasonable risk-management solution which isn’t too dangerous because, say you had 90 per cent of your portfolio in nine stocks and 10 per cent in a (volatility product), it’s going to move in the exact opposite direction of that portfolio,” Kerlow said.
Kerlow said the easiest way for investors to gain exposure to volatility is through ETFs and ETNs. The largest volatility ETN is the iPath S&P 500 VIX Short Term Futures ETN, which has seen its value rise to US$48.77 from US$26.95 on at the beginning of the year. An ETF equivalent — the Horizons’ S&P500 short-term futures ETF closed on Thursday at $8.63, up from $4.47 at the beginning of the year.
What can make the strategy a bit more risky and complicated for investors during a bull market is that they usually have to wait for an event that has a wide-scale effect on the markets, like the October market rout, to happen before they can make money. Without one, investors develop a negative roll yield because the options that product managers are buying are expiring. The longer it takes for volatility to show up in those two months, the less valuable the option becomes because it grows closer to maturity.
The time decay works in the favour of investors in inverse VIX ETFs, which essentially function as products that short volatility. If investors are bullish and think the market is going to outperform, holding the option longer will earn them more money. But it’s here, Kerlow warns, that investors can really get themselves into trouble because if market volatility does present itself, they lose a significant amount of money.
The strategy is kind of like picking up nickels in front of a steamroller. It works great as you pick them up, but if you get your shoelace caught, it’s all over
Chris Kerlow, Richardson GMP Asset Management portfolio manager
“The strategy in a way is kind of like picking up nickels in front of a steamroller,” he said. “It works great as you pick them up, but if you get your shoelace caught, it’s all over.”
In February, the VIX recorded its largest spike in history, leaping to over 50 points from just over 13 in three days. The jump led to some inverse VIX ETF products losing more than 90 per cent of their value and being pulled from the markets.
Those who are looking for a safer option could invest in either covered call ETFs or put options during higher times of volatility, said Nicolas Piquard, Horizons ETFs portfolio manager and options strategist. Investors can use put options to play defence from the volatility by paying a premium to have the right to sell on an index like the S&P500 at a certain level.
In mid-day trading on Thursday, the index was floating around 2,415 points. At that level, Piquard said, investors could bet that the index would fall an additional five per cent to 2,300 points in January and only pay little more than a one per cent premium — about 33 points — to do so.
The strategy is safer than inverse VIX investing and short selling because the most an investor can lose if their bet doesn’t work is the premium they paid to make it, he said.