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How to Prepare for the Coming Market Volatility

Written By Briton Ryle

Posted February 7, 2015

The investment world is currently in a state of transition. In our rear-view mirror we can see the stretch of smoothly paved road of low volatility slowly fading away into the distance. Ahead of us is the rougher road of bumps and potholes, which is really the normal investing environment. It just seems a little out of place since we haven’t travelled this way in quite a few years.

Investors, therefore, need to adjust the way they navigate through this normal environment – on its way to normalizing, that is; it will still take some interest rate hikes before we get back to full normalcy. But the markets aren’t waiting for interest rates to rise, and have begun bouncing and rattling already.

Over the past two years as graphed below, the Chicago Board Options Exchange’s Volatility Index (VIX) had maintained a remarkably stable channel between 12 and 17, with only 4 pops above 19 from early 2013 until the fall of 2014. Yet since then, it has surged above 21 five times in the last four months, with four of those in the last two months.

managing volatility 1


Naturally, it can be pretty frustrating looking at your account statements to find that all the gains made yesterday are gone today. Is this way it’s going to be from now on? Isn’t there anything we can do to mitigate such volatility and ensure steadier growth for our portfolios going forward?

There is for those among us who don’t mind applying a little more care and attention, and becoming just a little bit more active in our trading. Just a little, mind you; we never want to over-trade, as the commissions would eat-up all your efforts.

Picking the Right Stocks

That little bit more care and attention I refer to shouldn’t make you nervous. It really shouldn’t require more than one day a week to open your trading platform and tweak your holdings a little bit. Some even leave it to just once a month. But for this to work we need to have the right holdings in the first place.

The whole idea behind harnessing the power of volatility is to trade at least two instruments that move at different rates, one like the tortoise and one like the hare in the proverbial race. Essentially, your hare-like stock is the one that will make the bulk of your profit, while your tortoise-like stock is where you will store those profits once you take them.

Ideally, then, the hare-stock should be a faster mover. In this case, volatility is good. On the other side, the tortoise-stock should be a more stable slower mover, preferably one that pays a nice dividend, since this is where you will be parking your cash and profit when they are not being carried by the hare. So you may as well be earning a little something for that store of cash.

In a very simple example, we might pair the fast moving ProShares UltraPro S&P500 (NYSE: UPRO) with the slow moving SPDR Dow Jones Industrial Average ETF (NYSE: DIA).

UPRO is one of the faster hares around, moving at 3x times the speed of the S&P 500 index. But it must be purchased with at least 90% cash, so you don’t have to worry about margin calls – unless the S&P 500 index falls more than 90%!

DIA, on the other hand, is one of the slower tortoises, moving at just 1x the Dow Jones Industrial Average, which is already less volatile than the S&P 500 index to begin with. Plus, the DIA pays a decent dividend currently yielding some 2.1% per year. Not great, but the holding does have other advantages.

The whole idea here is to take advantage of UPRO’s rapid movement to generate profit quickly on the upside, trim a small portion off of it by selling a few shares, and then parking that trimmed amount in DIA by purchasing a few shares there. When the market reverses, UPRO would conversely fall more than DIA, at which time we would use some of our cash stored in DIA (which will also fall, but not nearly as much) to purchase some UPRO shares at drastically cheaper prices. Then we wait for the market to turn upward, and repeat the process.

Now we get to that great advantage that DIA has over the many other choices we could use as the tortoise.

What’s great about DIA is that it will continue to move up with the market during a bull run. Hence, there would be no fear that our store of profit and cash would be lagging. It would at the very least be keeping pace 1-to-1 with the Dow Jones Industrial Average. Plus we still collect its small dividend.

What we wouldn’t want to choose as our tortoise-like store of profit and cash is a stock or ETF that moves contra-market, such as a short ETF, also known as “bear-market funds”. Why not? Because the overall trend of the stock market is always up over time. If we pair together a pro-market mover like UPRO with a contra-market mover like, say, the ProShares Short S&P 500 (NYSE: SH), our store of cash would be eroding over time as markets continue reaching new all-time highs over the coming years and decades. It would be like carrying water from a well using a bucket with holes in it.

Two Basic Units of Measure

But a question now arises: how do we determine how much to move from one holding to the other? There are two simple ways to choose from.

First, you can trade in dollar amounts, adjusting the number of shares traded for each stock accordingly. In this case, all you need to look at is the dollar value of your two positions. Whenever one is worth more than the other, you trade half of the amount of that surplus out of the leader and into the trailer.

For example: You begin with $10,000 in UPRO and $10,000 in DIA. A week later you see that your UPRO position is worth $12,000 while your DIA position is worth $10,600. You move half of the surplus sitting in UPRO ($1,400 divided by 2 = $700) out of UPRO and into DIA. The two positions are now rebalanced at $11,300 each.

Second, you can trade in percentage terms of your overall account. If you want to allocate a certain percentage of your total portfolio into such a relative-value-trading mechanism, say 20%, you might allocate 10% of your account total to UPRO and 10% of your account total to DIA. Over time, as all of your positions change in value, you simply calculate 10% of your new total portfolio balance and adjust your UPRO and DIA positions accordingly.

The percentage basis is best when you want to keep your positions restricted to predetermined amounts of your overall portfolio. The cash basis, on the other hand, will grow larger in bull runs and shrink smaller in bear markets, resulting in its occupying an ever changing percentage of your overall portfolio.

Broadening Across Multiple Sectors

Of course, this mechanism of pitting a fast moving instrument against a slow moving one and then regularly shifting funds between them does not need to be limited to just two instruments, but can be spread out over multiple holdings.

For instance, one viable version is to hold an assortment of sector funds, rebalancing them as the sectors rotate over time. Numerous investment fund companies offer multiple sector-specific ETFs, including the SPDR Select Sector Funds, currently numbering 9 sector ETFs in all, as graphed below.

The great thing about using more than two vehicles is that there will be more opportunities for disparities to occur, and consequently more opportunities to lock-in profit, as graphed below.

To the left of the graph we see the performances of all 9 SPDR sector ETFs with their percentage changes over six months from February to August 2014 (just the final month of which is depicted). To the right we see the performances of the same funds with their percentage changes over the most recent six months from August 2014 to February 2015 (again, just the final month of which is depicted).

While the top performer in the first six months was the energy sector (purple), during the most recent six months energy was the worst. A similar fate befell the technology sector (light gray) which fell from second to seventh, as well as the materials sector (green) which fell from third to eighth.

Meanwhile, the healthcare sector (yellow) jumped from fourth to second, staples (blue) jumped from fifth to third, consumer discretionary (brown) jumped from eighth to fourth, and industrials (dark gray) jumped from ninth to fifth.

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Regular Maintenance Keeps Your Portfolio Humming

Within this dynamically charged trading environment there are plenty of profits to be had. And all it takes is a simply maintenance program of rebalancing our positions every week or two. Some professional money managers will space their re-balancing to just once per quarter.

Whatever the frequency, stock selections and base measurement you use, the rebalancing of our holdings can be an invaluable aid to locking-in profit without having to sacrifice further upside potential, since our positions would still remain open to benefit from further growth.

What is more, periodic rebalancing allows us to capitalize on temporary weakness in certain sectors of the economy which can offer substantial profit potential once they strengthen again. And if we use simple shifting in dollar or percentage amounts, we don’t even need to put new money into our accounts to take advantage of these opportunities. We could handle it all with just the funds that we have there already.

Joseph Cafariello