Rule #1 Finance Blog

With Investor Phil Town

Understanding Stock Market Volatility and How to Profit From It

Stock market volatility may sound scary, but it’s actually essential in order for Rule #1 investors to be successful. It’s the reason why there are opportunities to purchase great companies at great prices.

Today, I’ll get into exactly what is market volatility and why you shouldn’t be afraid of it.

What is Market Volatility?

Before we get started, let’s make sure you understand the basics of market volatility since the words get tossed around a lot.

Market Volatility Definition: How much the stock market moves up or down compared to normal. If it is moving up and down more than normal, it is considered to be a volatile market.

When we talk about market volatility, we are talking about stock market volatility, but volatility can also refer to individual stocks. What is “normal” is defined by the average movement of the market or stock over a defined period of time.

Market volatility is typically associated with risk, but without it, investors wouldn’t have the same opportunities to buy low and sell high. Before we dive into how to profit from market volatility, let’s make sure you understand the basics of what market volatility is and how it impacts companies in the stock market.

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Volatile Stock vs. Volatile Market

Based on the market volatility definition above, volatility can refer to the market as a whole or to a singular stock.

If we are referring to a specific stock when we talk about volatility, it means that the price of the stock is moving around more than usual.

For example, cryptocurrency stocks are known for being extremely volatile; their prices rise and fall dramatically from one day to the next. However, if this behavior continues over time, it will be called less volatile because it is the stock’s normal behavior.

When we talk about a volatile market, on the other hand, we are referring to the big up or down movements of the stock market at large. The S&P 500, a collection of the 500 largest publicly traded stocks, is typically used to reflect the market as a whole, so we’ll use it for this example.

If the S&P 500 rises or falls by more than 1% over a sustained amount of time we consider the market to be volatile, as we have seen over the course of the pandemic.

Both individual stocks and the S&P 500 generally move around over the course of a day. This isn’t considered volatile. You want to pay attention to the prices at the close of each day over the course of a certain period of time to determine if the market or an individual stock is acting volatile.



Stock Market Volatility Index

Market volatility is measured using the Volatility Index called VIX, which was created by the Chicago Board Options Exchange (CBOE).

The index measures the 30-day expected volatility of the stock market based on options traded on the S&P 500. When you trade options, you are essentially betting that the price of the stock will rise or fall by a certain date.

The S&P 500 Index options signal whether or not investors think the market will go up or down.

VIX is also referred to as the “Fear Index” because the greater the reading, the more investors there are betting the market will go down, and so, the greater the risk. When the market volatility index, or calculated risk rises, it typically causes the S&P 500 to fall. Historically, high VIX readings imply an impending bear market.



Implied vs. Historical Market Volatility

VIX is an indicator of implied volatility. Implied volatility looks forward, estimating the future volatility of the market or stock based on put and call options. It estimates the potential of the option in the market and shows how much that asset may move, but not the direction of the movement, up or down.

Historical market volatility, on the other hand, measures how volatile the market has been historically. It is useful for understanding the standard amount of volatility that is normal behavior for an index or an individual stock but doesn’t have any bearing on how volatile it will be in the future.

It also indicates the uncertainty surrounding an asset. For example, if historical volatility falls for a stock, it’s a sign that there is now less uncertainty surrounding that stock.

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What Causes Market Volatility?

Stock market volatility is largely caused by uncertainty, which can be influenced by interest rates tax changes, inflation rates, and other monetary policies but it is also affected by industry changes and national and global events.

At this point in time, the Fed is taking extensive monetary action, many industries and sectors of business are vastly changing, and uncertainty is rampant due to the coronavirus. This explains what is causing the stock market volatility in the current market.

In times of uncertainty such as this, there is a lot of fear around what the future holds, so we can expect to experience a volatile market.



How to Calculate Volatility

There’s some serious math going on when calculating volatility.

Once you have chosen the period of time and a particular stock or index you want to calculate volatility for, you need to create a data set by pulling the prices of that particular asset over the set period of time.

You can then perform a number of calculations on the data set to determine its volatility.

First, find the mean, or average, of the data set by adding up each value and dividing the sum by the number of values in the data set. Then, find the deviation of each value from the mean and square it.

Add up all of the squared deviations and divide the sum by the number of values in the data set. Now, you have the variance.

You can then calculate the standard deviation by taking the square root of the variance. The standard deviation shows how much the price of the stock or index could deviate from the mean of the asset over time. It is the asset’s volatility or risk.

That standard deviation can then be compared to historic standard deviation averages to determine whether or not current volatility is “normal” compared to long term volatility.

When comparing where we are now to the recession of 2008, market volatility has been incredibly higher in the first 6 months of 2020 than it was 12 years ago.

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Additional Indicator of Volatility

If you don’t want to calculate volatility on your own, you can use the Volatility Index (VIX) to gauge market volatility and option prices or beta values to gauge stock volatility. A beta value will tell you how volatile a stock is compared to a benchmark, most commonly the S&P 500.

Most brokerages will list a stocks beta value: a value close to 1.00 will be the least volatile while a value farther from 1.00 will be the most volatile.

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How To Predict Market Volatility

While we can calculate both implied and historical market volatility, neither will predict future volatility.

If the market were predictable, we wouldn’t have market volatility in the first place. In fact, volatile markets are even more unpredictable and considered riskier because of it. So the better questions are how to plan for volatility and how to take advantage of stock market volatility when it comes.

How To Profit from Market Volatility

While planning for stock market volatility may sound a little like planning for a storm you don’t see coming, it’s actually something we as Rule #1 investors can look forward to. We actually like volatility.

A volatile market qualifies as a Rule #1 event and can provide great opportunities to invest. A Rule #1 event is something that has happened to the general market that causes it to price a business well below its true value.

A volatile stock market qualifies as an event because it induces fear in the market, which can cause great companies to be priced well below what they are actually worth.

When a company’s price drops as a result of volatility, it is effectively “on sale” and we can buy it. We like volatility when it’s going down because we can buy it, but we also like volatility when it’s going up.

If we buy a business at it’s “on sale” price, then when its price spikes as a result of volatility, we can get a return on our money much more quickly. Typically, a volatile market will correct in 2-3 years, which means your money can double or triple in that time.

If we as good researchers know the value of that company, we can feel confident that it will recover from a dip in the market in a few years. So, what makes a great company and how do you determine if it is a great investment in a volatile market?

Best Investments In a Volatile Market

When there is stock market volatility, it’s not an excuse to buy any company because its price has fallen.

The best investments are still in wonderful businesses that will rebound from falling prices and give you a great return on your money. If you aren’t sure what makes up a wonderful business, focus on these 4 Important Financial Metrics to Help Evaluate a Company.

If you can find companies that have little to no debt, a proven track record of success, and strong management, investing in volatile markets will help you grow your portfolio bountifully.

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1. Little to No Debt

One of the first things to consider when looking for the best investments to make in a volatile market is whether or not the company has debt. Ideally, you would only invest in a company that has zero debt. In a fluctuating market, a lot of debt opens the door to potential bankruptcy, which is bad. The more debt a company has the more risky investing in it is.

2. Proven Track Record

Secondly, the best indication of how a company will perform in a volatile market is how it has performed in volatile markets of the past.

If the market is super volatile, be aware that it might be a turbulent time for the company and it may experience losses. Look to see how the company reacted and recovered during other times of volatility such as the 2007 stock market crash.

Did it thrive or struggle when the recession was over? If the company did well during and post-recession last time, it’s a good sign it might be able to come out on top again this time.



3. Strong Management

Lastly, a great leader (or a bad one) can make all the difference in how the company performs. With any investment, it’s important that you can trust the leadership with the way they will take the company, but it’s especially important when the market is volatile.

I go into greater detail here on how you can sort strong leaders from weak ones so you know your investment is in good hands.

Stock Market Volatility and Learning

For Rule #1 investors, volatility doesn’t equal risk. For us, the risk is based on how much you do or don’t know, not how volatile the market is. In fact, we need volatility in order to get companies at great prices and get great returns on our investments.

Market volatility can cause fear for a lot of people but the ups and downs of the stock market can create great opportunities for Rule #1 investors. If you can get comfortable investing when there is volatility, you can invest in wonderful businesses when they are on sale and watch your money grow and quickly.

The best thing you can do to limit your risk is to get educated.

Join me for a Rule #1 Transformational Investing Workshop and get a handle on how to invest best during times of uncertainty and beyond.

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Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.