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9/21/15

Why It's Great to See Market Crashes

Today I want to tell you about one of the most counter-intuitive things you'll ever hear in the world of finance.

If you've been watching the financial markets at all over the past few weeks, you must know that the strategy of the average investor--buying stocks, collecting a few dividends, and hoping what you buy goes up in price--is far from guaranteed to make you a lot of money.

You don't even have to turn on the television to know the markets took a massive dive lately--in August alone, the markets lost 10% of their value over the course of only a few days. It's been quite a ride.

It's times like these that financial advisers, the career a few friends of mine have opted for, find themselves the most busy. Every one of their clients and their dog are calling them up in panic, freaking out, wondering what they need to do with their investments or nest egg. Consequently, advisers also "cash in," so to speak, during market panics, because they rack up tons of fees making adjustments to client investment holdings. Not a bad business model, from their perspective.

Yes... volatility has returned to the markets, and most agree that it's not going away any time soon.

Most financial advisers, and even self-directed investors, for that matter (which is what I'm trying to turn you into) avoid volatility. It's a dirty word. The town pariah. The leperous stepbrother with the skin falling off, whom no one wants to touch.

If you're in the business of managing someone else's money, "buying" volatility, or putting your clients' money to work in the more risky asset classes, especially if you don't know what you're doing, is a sure-fire way to get your clients to transfer their assets to a more risk-averse asset manager, and to doom yourself to bankruptcy.

But when you know what you're doing... you'll makes fortunes.

Volatility: The Great Divider Between Rich and Poor, Smart and Dumb

So, what is volatility, anyway?

It's a measure of the degree of change in the value of an investment over a certain period of time, particularly underscoring the degree of negative change occurring in the markets.

In other words, if volatility in the stock market is low, like it has been for years it seems, it means stock prices have been going up, without much deviation to the downside. The markets look something like this:

On the other hand, if volatility is extremely high, it means stock prices have been plummeting extremely quickly. The markets look something like this:

That's what a 10% correction looks like. That's what happened in late August.

Volatility is tracked in the financial markets by an index called the VIX. It's referred to by most as the "fear gauge", because when the VIX is high, market pandemonium is ensuing. Here's a recent chart, showing the level of the VIX for the past two years:

The red arrow from the second chart, and the green arrow from the second, highlight the same market movement. So, you can see how the two function inversely. You can also see that August was the most volatile time in almost four years.

Risk-tolerant investors tend to put their money into investments which are extremely volatile, because they're hoping that over a short period of time, they can make a lot of money--but that doesn't always work out in their favor.

By far, the most volatile financial instruments average investors use are stock options. Under extremely volatile environments, prices can swing by thousands of a percent in a single day. On even an average day, prices can move anywhere from 20-50%.

An alternative title for today's article could be "Volatility Is Big Money, If You Use It Right." Investing in volatility means that either money is coming your way, or it's leaving you, and quickly.

Most people use it in the wrong way, or the risky way. Instead of acting like sophisticated investors, they take on the role of stock market gamblers, thinking they can make a quick buck overnight.

That's why I said at the beginning of this article that what I was about to explain was so counter-intuitive: A) Smart money doesn't flee volatility, it waits for it, and B) The smart way to make money on volatility is counter to the way 99% of investors use it.

Here's a bit of proof for you.

In case you haven't heard the name, the most notorious investment bank in the world is Goldman Sachs. This company makes billions of dollars per year managing money, selling investment advice, and speculating (wisely) in different kinds of assets. The company is so good at what it does, its win rate in trading is 94%.

Out of 251 trading days during the year 2013, this bank made net profits on 236 of them. How would you like a record like that?

So, you ask, what is the company's secret?

There are sloughs of former Goldman Sachs traders entrenched in the industry... many end up working for the Federal Reserve, some start their own management funds, others write newsletters and advisories... and from what I've seen, they all write the same thing about options as they cash in with their "memoirs." Here's the secret...

Goldman Sachs doesn't buy stock options on equities, typically.... it sells them. The company's millions of dollars per year invested in analytics allows them to make huge profits (over time, small percentages per day, not in windfalls of hundreds of percent) by cashing in on changes in volatility. They sell options when volatility is high, and when volatility dies down, they buy back what they sold, for a lower cost, and a net profit.

Individual investors, who don't understand this philosophy, buy volatility (volatile stocks and options), when they should be selling it. The same mantra of "buy low, selling high" applies to options trading.... and as we know, in order to make money, you need to "buy low, sell high."

Let me give you an example. Last month, I wrote about how I double the market's historical return by simply agreeing with my broker to sell some shares I own at a higher price than I bought them, using an instrument called a "covered call option."

At the time, markets were still on their skyward march into oblivion. Volatility was still extremely low.

I agreed with my broker to make 2% on my money over the next 30 days by agreeing to sell some shares I owned, an annualized gain of 24% a year. Again, volatility was low, so options premiums were not very "fat."

Compare that time around the beginning of August to the trading environment of today. Making the same trade right now, when implied (or "predicted") volatility is much higher, I can earn as much as 3.4% over the next month--put another way, that's 66% juicier. Much "fatter."

This is because the premium I receive for agreeing to sell my shares is much higher, due to the volatility in the markets. Volatility inflates options premiums. Or, as a professor of mine always used to tell me, "Options are the price of volatility." And volatility is now somewhat higher of late... but not as high as it was in August.

Don't fear market crashes - Cheer them on!

Successful investors, who hold rock-solid investment portfolios made up of shares of industry-dominating dividend-payers, sleep well at night, and watch the markets with interest by day for times when volatility has increased--when shares of great companies have irrationally decreased to cheaper levels. When that happens, they can buy more shares and sell options against them to make a killing.

Everyone from fund managers, investment bankers, to portfolio managers all use implied volatility as a central part of their asset hedging strategies and equity valuations. It's often used as a measure of risk.

I use it as a market gauge, to know when I can get the juiciest returns, in the shortest period of time, with the smallest amount of risk to my savings.

By watching market indexes like the VIX (most widely traded under the ticker symbol VXX), you can know when the best time is to sell put or call options on the safest stocks in the market, in order to generate above-average returns. Doing so can cut your working life in half, as I've written before.

Isn't that the most ideal way to invest? Quick, juicy, and low-risk?

Live long and invest,

Jeremiah

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