Currently, the stock markets are showing very erratic movements. The contrast in the market behavior between the first half of November and the second could not have been more. Around Diwali, the stock markets were cruising along, confident of reaching new highs. The 'Obama vote of confidence', combined with positive economic data, created positive market sentiments, which gave the impression nothing could go wrong with the domestic markets. But in a matter of two weeks all that confidence has evaporated.
Triggered by global factors such as the Chinese rate hikes, the markets fell steeply by almost 10 percent. Suddenly, the picture seems a little less rosy. Despite analysts' inability to pinpoint the exact reasons for the fall, one factor stands out. The markets were highly volatile and this back-and-forth action showed that volatility is central to stock markets.
Why is this volatility so pronounced now?
The uncertainties on the economic front increased last month with reports of a potential debt emergency in several European countries and rate hikes in China. Wide price fluctuations are a daily occurrence in the world's stock markets as investors react to various events across the globe, whether it is economic, business or political. So, the market volatility is just an indicator of economic uncertainty.
Arriving at volatility
When the stock market goes up one day, and then goes down for the next few days, then up again, and then down again, this erratic movement is called market volatility. Volatility is arrived at by calculating the annualised standard deviation of the daily change in prices. Volatility does not measure the direction of price changes, but merely their dispersion.
Two stocks with different volatilities may have the same expected returns, but the stock with the higher volatility will have larger swings in prices over a given period of time.
Volatility can be measured
In India, the measure for volatility is called India VIX. India VIX is a volatility index based on the Nifty Index Option prices. Volatility Index is a measure of the market's expectations of volatility over a near term. From the best bid-ask prices of Nifty Options contracts, a volatility figure (in percentage) is calculated. It indicates the expected market volatility over the next 30 calendar days.
A high VIX appears just before a market rally, and a low VIX usually augurs a slide. Historical data has shown that wild market movements precede a change in the market's direction. Dealing with volatility is not impossible. Investors have to devise some strategies to deal with it.
Some strategies for investors to beat volatility:
Dividend investing
One method could be to invest in companies that have a good track record of paying dividends.
This style of investing is called dividend investing and is usually adopted by investors looking for safe investments. A long-term investment strategy, it withstands volatility.
Dividends of quality companies have grown at an average annual rate of 18 percent in the last 10 years. When following a dividend investing strategy, investors have to do their homework to ensure that the quality of dividends paid is good and they are coming from excess operational cash flows, and not debt, to ensure sustainability.
Options
Options are good to handle volatility. They can offer high returns during any market condition. They are especially good during times of uncertainty. Volatility is such an important factor in the price of an option that a change of one percent in volatility has a significant influence to the price of an option.
Options are inexpensive when the volatility is low and expensive when it is high. Option selling plays on both stock prices and volatility. Investors can therefore sell options to hedge their portfolio.
Systematic investment plan
While most investors know that equity provides an opportunity for better returns than most other asset classes over a longer duration, it is the fear of volatility that keeps investors out of the stock markets. The systematic investment plan (SIP) is one of the most efficient ways to benefit from volatility.
The markets move up and down over a period of time. By investing through a SIP, you have the opportunity to enter at every stage of the market. A SIP works on the concept of law of averages. It makes the average price of the investment a weighted average, thus reducing the average cost of purchase of units.
Track charts
Investors should track technical charts during times of volatility. During volatile times, they are likely to be more useful and informative than conflicting economic factors that give confusing signals.
