Market Beat: Cycles of volatility in stock market
The stock market goes through cycles of volatility on a fairly regular basis. The majority of the time, about 85 percent, the market is rising with relatively low volatility. The other 15 percent of the time, the market is falling with high volatility. These cycles are normal, but can be very unsettling to investors as the market can have some steep drops at times.
Corrections are normal in bull markets and typically occur about every 18 months. A correction is defined as a drop of at least 10 percent. Bear markets also occur periodically and are defined as a decline of 20 percent that lasts at least six months.
The market topped out at record levels on Jan. 26 and has entered into correction territory since then. We have recently seen the largest point drop in Dow history, on Feb. 5, the Dow dropped 1,579 points intraday and that was the largest point drop ever. In percentage terms, the Dow has fallen much more in the past. In 1933, the Dow fell over 15 percent in one day.
There are a variety of tools that investors can use to hedge their portfolio, but it is very tough to have a thorough understanding of how these hedging strategies work.
The use of the term, “hedge” has an interesting history. In the medieval days people would plant hedges around their property as a form of defense like a fence. The use of the word hedge to describe a defensive strategy for a stock portfolio goes back to the early days of the stock market.
Inverse exchange traded funds, or ETFs, can be one good way, but investors should use caution when using them. Inverse and leveraged inverse funds are designed to move opposite the underlying index on a daily basis only and may not work well when held over longer time frames.
Volatility based ETFs can be good for hedging, but once again caution should be used when employing them. There are funds that will increase in value when the market drops and volatility rises, but they are not long term investments, so you must decide when to use them.
Recently an inverse volatility fund, which had been quite popular with traders, dropped over 90 percent during the recent volatility spike and may not ever recover. That fund was quite popular with traders who were convinced that we would stay in a low volatility cycle for much longer.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.