How To Adapt To A Volatile Market

Volatility.

Some people fear volatility, while others welcome it with open arms.

The term volatility is often associated to fear of the stock market. When volatility is high, it means that people are uncertain and fearful. And when volatility is low, its means people are more certain and confident.

In this blog post, I am going to discuss how to look at volatility, and also, the strategies when investing when markets are getting volatile.

How To Measure Volatility

There is stock market index, that specifically measures the volatility of the US stock market, called the VIX.

The VIX is also fondly called as the "fear" index.

When we go back to the March 2020 Covid-19 market downturn, we saw a spike in the VIX.

The VIX went all the way to 80 - this was unprecedented.

The last time the VIX ever went above 80 was during the 2008 crisis.

There's probably no need to tell you that, if you were to invest in quality companies during the 2008 crisis, and have the courage the hold your shares - you would have made a ton of money.

Or what do you think? Should fear volatility or welcome it?

During the volatile periods, as the stock market falls, I will simply continue to buy quality undervalued companies.

I have to emphasize this over and over again. Continue to buy QUALITY UNDERVALUED COMPANIES.

Not EVERY company can recover from a crisis - especially those with poor fundamentals. Take a look at some of these companies that never recovered from COVID.

Many people has this concept that, "Oh if you invest during the market crash, where stock prices are so low, you are sure to make money!"

Let's address this first - "because stock prices are so low". Most people have the perspective of "low" means "cheap" - that's why they keep chasing stocks that are selling at less than $10...

If I were to sell you a rotten egg at $0.01 - it does not mean that egg is worth buying right?

(unless well, you want to throw it at someone...)

When investing in the stock market, focus on the fundamentals of the companies first, not the price.

So while it is true that a stock market crash is one of the biggest opportunities to multiply your money. However, this rule only applies to quality companies.

If you want to invest successfully in the event of a stock market crash, here are some rule you might want to follow:

1. Have cash to actually take advantage of these crashes
2. Invest only in quality companies
3. Average in as the price falls
4. Just hold the stocks and ride it

That's the first strategy for you - buy and hold QUALITY companies.  This strategy is simple, yet effective. Nothing fanciful.

The next strategy is something more interesting, and only suitable for those with a large portfolio.

Sell Insurance At Undervalued Prices

When the volatility is high, people are scared of the stock price falling.

Therefore, they want to buy "insurance" on their portfolio - otherwise known as put options.

What does buying a put option means? Watch this short animation video to find out.

When it comes to put options, I will always be the option seller. This means that I am the one who will collect the option premium.

When the volatility of the stock market is high, the option premium that I collect will also be much more. Why? Because there is a lot of fear in the market, and people are all worried that the share prices will fall.

In fact, during the March 2020 Covid crisis, when the VIX spiked, I collected over $5,000 in option premium.

This is the second strategy, which is selling put options. Of course, there are specific rules to execute this strategy, which I am going to share with you next.

What Not To Do During High Volatility

The above are the two strategies that worked well for me especially during high volatility.

Now, I want to discuss what I wouldn't do especially during high volatility. Of course, these are just my personal take - feel free to adapt it to your own investing style.

I wouldn't buy call options. Remember when I said that during high volatility, option premiums are more expensive. This applies to call options as well. This means that if I were to buy call options during high volatility, I will effectively be paying extra of these call options.

Also, high volatility can lead to a long market downturn and nobody know when the stock market will recover. Remember that when we buy call options, there will be time decay that is eating into our profits. Personally, I wouldn't want to bet against time - which is why I will much rather buy and hold stocks since buying stocks do not have time decay.

Secondly, I will not use margin to invest in stocks. Purchasing stocks on margin can greatly amplify the effects of losses. Additionally, the broker may issue a margin call, which requires you to liquidate your position in a stock or front more capital to keep your investment. This is especially so when you try to sell naked put options...

Remember that if we were to sell put options, we are promising to buy 100 shares of the underlying stock at the specified strike price.

So if you were to sell a put option at a strike price of $65 - you need to ensure that you have $6,500 in cash in your brokerage account. If you do not have that amount of cash, if the stock were to fall sharply, it could lead to a margin call, and if you do not meet the margin requirements, it would lead to huge wipeout in your portfolio.

What's Next?

In this blog post, we discussed two main strategies for investing in a volatile market - which is buying and holding quality companies, and selling put options to take advantage of the increased premium.

We also covered why I wouldn't use call options or margin during a volatile market.

Now, it is time to also share with you where you can find out more about executing these strategies using the resource hub as Passive Seeds - The Stock Investing Hub, and the Options Investing Hub - where we cover everything from fundamentals, valuations, entry rules and exit rules.

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