Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

3 Ways to Play the Market's Volatility

Warren Buffett's #1 rule is to never lose money. His #2 rule? Never forget Rule #1.

When you lose money, you need to generate an even higher return to break even. So how can an investor avoid losing money during these especially volatile economic and financial times?

Hold Cash

Having trouble sleeping at night? Then sell the stocks troubling you. In some cases, it makes sense to raise cash by taking profits or closing out a losing position during periods of extreme volatility.  Return of capital rather than return on capital is especially important during recessions and depressions. When the market settles down and you have more confidence in what the future holds, you can redeploy your cash to take advantage of coming trends. 

While you can always sell your stock using a market order, many investors use stops to lock in their exit point. If the stop price is reached, the stock is automatically sold. By setting a stop price ahead of time, the emotion of a market plunge can be mitigated. Trailing stops, a cousin to the straight stop orders, are also great tools for investors who want to protect their capital during a plunge in the market, but still want a chance to lock in gains if the stock continues to advance. 

The downside to using stops is that your order price can be seen by market makers or sophisticated trading programs. While they are not supposed to purposefully drive the price down to the stop, there is a lot of anecdotal evidence to suggest that firms with high-powered computer algorithms can sniff out and exploit stop prices. Once all the little guys' stops are triggered and the price falls, the trading algorithms scoop up the shares they just forced to be sold and the price pops back up, never to see the stop price again. 

The highly disciplined investor can avoid this fate by committing to an exit price without entering it with a broker. When the price reaches the predetermined stop level, he or she must have the self-discipline to sell according to the original plan.

Either method can work, depending on your personality. You need to know yourself. Choose your method wisely.

With your cash safely stored in the bank, you have the luxury to wait for the market settle down. In the mean time, you can sleep well knowing that your capital is safe.

Focus on Long-term Rising Trends

Over the long term, winners ride the trend. Throughout history, there have been important trends that defined investing opportunities over years or even decades. Long-term investors weight their portfolios toward sectors and companies that take advantage of the important trends. Being on the right side of the trend is a winning strategy, and market volatility actually works in your favor by giving you ample buying opportunities when desirable sectors and companies are thrown into the bargain bin.

For example, Europe is undergoing a painful retrenching. The high debt load many EU countries have accumulated means they will likely struggle through a sustained period of low growth as they pay off the loans. European governments are cutting wages and benefits in the public sector, and private companies will likely follow. Lower wages mean lower consumer spending, making it unlikely the EU consumer will be able to pull the continent out of its economic doldrums. Factor in the potential that the European Union as a political body could fall apart, and it becomes apparent that the trend for investing in Europe is down.

The United States economy is in the midst of a painful jobless growth scenario. While the U.S. economy will expand, it will not grow fast enough to absorb all those who wish to work. According to economists, the economy must create 100,000 to 125,000 new jobs each month to keep up with those entering the work force. That doesn't even take into account the more than 8 million people who lost their jobs in the latest recession. Because high unemployment drags on the consumer (which makes up 65-70% of the U.S. economy), and the slow economy drags on the supply of jobs, the U.S. may be stuck in first gear for quite some time. 

On the other hand, Asia and parts of Latin America are growing on their own. China, India and countries in Latin and South America are almost certainly going to experience significant long-term growth as a higher percentage of their significant populations move out of poverty and into the middle class. Position your portfolio by owning more shares of companies that will benefit from this long-term trend. 

Buy Protection

You buy auto insurance to protect against a major car accident. Why not buy insurance against a drop in share price? 

One of the easiest ways for individual investors to buy insurance against price declines is by buying a put option against the shares you already own. Known as a protective put, the value of the put option will increase when the value of the shares you own decline. Should the price of your shares fall, you can sell the put option at a profit and offset the loss on your underlying shares. Or you can hold the put until expiration, at which point you sell your shares at the strike price that is higher than the current share value. The downside is that the cost of this insurance (the premium of the put options) increases as market volatility increases. (Click here to read another Hans Wagner article focusing on this option strategy.)

Professional traders and portfolio managers do everything they can to avoid breaking Buffett's #1 rule. Now that you know what tools to use, you can do the same. Then you can get a good night's sleep.