Dealing with Volatility

The strong rise in price in the equity markets and the subsequent increase in volatility are enough to make even the most experienced investor dizzy. When the markets become increasingly tumultuous, investors should focus on several things: remaining calm, preserving capital and seeking high quality opportunities. Familiarizing yourself with the right analysis techniques can prepare you to be on the right side of the markets even when these seemingly random news items occur.

Technical analysis has worked exceptionally well in predicting the potential movements of the markets even with the increased volatility. For instance, an investor who understands how to identify the proper supply and demand zones can recognize potential danger areas to book profits or protect their positions when trends do change. Anyone who has held onto positions during the 2008 bear market will undoubtedly understand the need for identifying the dangers so you can avoid the pain of watching your portfolio value deteriorate.

The key thing to remember when doing your analysis is that you are an investor and that you should not allow yourself to get scared out of positions from only a minor retracement in price action. Investors can filter these smaller movements often referred to as “market noise,” by ignoring smaller time frame charts and focusing only on the bigger picture of weekly or monthly charts. When those trends do brake and reverse, then the investor may want to shift to other asset classes for safety and/or profit.

Technical analysis allows us to identify when the market is telling us to exit. That is when we need to act. The largest barrier to our investing properly is often us. We micromanage our positions and succumb to the news we hear as fear forces us to exit from quality positions prematurely and hold onto losing stocks far too long. When markets start to get volatile, just remember, “Do Not Panic!” Stay focused on the reasons why you entered the position and if those reasons and the trend have not changed, there is no reason for you to exit.

Another common error that many investors make is to buy puts to protect their portfolio positions as the market corrects. Most people are aware of options but do not understand them fully. The price of a stock is only one factor that determines the pricing of an option.
Volatility, which usually increases as prices in the markets fall, is a major factor in option values. By buying a put after the prices have fallen, you are paying more for the insurance and increasing your cost basis. Cost basis is the amount you paid for the stock position. The money you spend on puts for stock you bought raises the amount you had to pay as you are spending to protect and maintain that position.

A smart investor can even add to their returns while reducing their cost basis by utilizing a simple strategy of selling call options against the stock positions in their portfolio. A call option allows you to “lock” in a purchase price of a stock even though the price may be higher in the future. In essence, the call option buyer has the right to buy or “call away” stock from the option seller at a pre-determined price (called the strike price) at the end of the options expiration.

In India, the option trades are not settled at the expiration with an actual transfer of shares but rather cash settled between the buyer and seller by transferring the difference between the current market price of the stock at expiration and the strike price. Should the price of the stock rise above the strike price of the call you sold, you would have to pay the difference between the market price of the stock and the strike price. However, your gains in owning the stock itself would offset that loss.

If placed correctly, the covered call option should offer a steady income with relatively low risk. You want to sell the strike price above a resistance level at an area where you believe prices will not likely reach prior to expiration of the contract. You collect the premium of the option as your profit. The profit received from the sale of the call does something else for the investor: it reduces the cost basis for the stock and offers some limited downside protection. Buying a stock for Rs. 900 and selling a call for Rs. 15 drops your cost basis to Rs. 985. The price of the stock could drop to 985 before you start losing in your portfolio. If the price rises, you earn from the premium received as well as the rise in price in the stock.

Most people incorrectly believe that it must take a long period of study for them to be able to make educated decisions in the markets. The truth is that by taking a little time to educate yourself, you can make decisions that could literally change the quality of your life. What is that positive change worth to you?

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