The past few years have seen volatility in the financial market rise sharply. The CBOE Volatility Index (VIX) rose to an all-time high of $85 in 2020 after Covid was named a global pandemic. Since then, the index has remained being volatile as shown in the chart below.
In this article, we will look at some of the common causes of market volatility and how you can protect yourself from such scenarios.
Causes of market volatility
There are many causes of volatility in the financial market. Let us look at some of those that happened in the past few years.
First, euphoria in the market can lead to volatility when liquidity dries up. For example, in late 1990s, most investors were buying all types of companies provided that they had a dot com suffix in them.
Their hope was that these companies would continue doing well in the long term. The situation ended in the dot com bubble when most technology stocks dropped.
Sadly, such situations have happened many times before. For example, in the past few years, many people rushed to invest in electric vehicle companies. The idea was to invest in future Teslas and benefit as the shares rose.
Also, we have seen this performance in the cryptocurrency industry. In most cases, these people have lost a lot of money.
Second, volatility can be caused by the Federal Reserve. In most cases, stocks and other assets tend to be more volatile when the Fed turns hawkish.
Historically, investors tend to dislike periods of high interest rates. The chart above shows that the Nasdaq 100 index was a bit volatile in early 2022 as the Fed started hiking interest rates.
» Related: Trading Under The FED Decisions
Further, geopolitical events can lead to substantial volatility in the market. A good example of this was what happened during the Russian invasion of Ukraine in 2022. This volatility happened because of the rising commodity prices and the fact that most investors were unsure about the overall impact of the invasion to the global economy.
In addition to the broad market volatility, single companies can be volatile as well. This volatility is caused by various things like:
- Earnings and guidance - In most cases, a company’s stock will be significantly volatile when a company publishes weak quarterly results. It can also be volatile when it delivers strong results and provides a weak forward guidance.
- Management change - A company’s stock can be volatile when there is a management change in the firm. This can happen when a beloved CEO dies or announces his resignation.
- Product news - A company can be volatile when it makes an announcement about its product. For example, this can happen when it announces a delay of a product launch.
- Short attack - A stock can be volatile when a prominent short-seller publishes a report critical of a company.
The chart below shows how the Facebook stock price declined sharply after it published weak results.
Strategies to protect yourself in high volatile markets
There are many approaches to protect your account in periods of high volatility.
In a previous article, we wrote about the dangers of timing the market. Ideally, there is always a risk when you start timing the entry point of a stock or any other asset. That’s because in a period of high volatility, it is always difficult to predict where the drop will end. It is almost impossible to call a floor of an asset.
Therefore, one way that investors use to protect their accounts and time the market well is known as dollar cost averaging. If you believe that a stock will rebound in the long term, you can decide to buy it over time.
For example, if you hav $12,000 to invest, you can decide to divide it into 3. In this case, you will have $4,000 to buy the stock as it drops. You can buy the stock when it drops to $10, $8, $7, and $6.
Therefore, if the stock bounces back, you will have generated more profits by buying the stock at different prices.
However, this strategy is not recommended to traders because the stock can take more time before it bounces back. Also, a major risk is that the stock could rebound before you allocate all your funds.
Another strategy is to use a stop-loss whenever you open a trade. A stop-loss is a tool that stops your trade automatically when it reaches a certain level. This is a mandatory tool that you should always have when opening a trade regardless of the market situation.
One way of using a stop-loss is to have a good risk-to-reward ratio. The most basic approach of using a risk-reward ratio is to consider the amount of money you are prepared to lose.
For example, you can decide that you are not ready to lose as much as 5% of your account. Therefore, if you have a $10,000 account, you should put your stop-loss where the stock loses $500.
Another way of protect your losses in times of volatility is to be diversified across multiple industries. What the past periods of high volatility have shown us is that companies are not exposed to the elements equally.
For example, during the Russian invasion of Ukraine, while most stocks declined, oil and gas and millitary contractors saw robust growth. Therefore, having a good diversified portfolio can help you a great deal achieve success.
Summary: Exploit volatility (almost risk-free)
In this article, we have looked at what volatility is and some strategies of avoiding it. Or, better, to prevent/mitigate the risks that this brings with it since as a day trader the periods with higher fluctuations are also the most profitable ones.
Some of these strategis are recommended on long-term investors. Other top strategies to consider are pairs trading, reducing your exposure, and limiting your leverage.
External useful resources
- 7 Things You Can Do During a Volatile Stock Market - Schwab